Right Tail Hedging: Managing Risk When Markets Melt Up

Abstract

Popular academic and practitioner lore claims that buying options, whether puts or calls, is a negative expected return investment and hence should not be undertaken by rational, risk-neutral investors. However, real-world considerations such as the possibility of large jumps and imitative behavior of traders in both bull and bear markets can reverse this conclusion. In particular, the potential for positive economic shocks such as those observed since the 2016 U.S. election may make call options–based strategies superior to buy and hold strategies. In this article, the author extends his work published in The Journal of Portfolio Management in 2007 on left tail or downside tail risk hedging to address upside hedging, which has become increasingly relevant in an environment of low yields, elevated asset prices, low credit spreads, indexation, and multidecadal lows in call option prices.

TOPICS: Portfolio construction, options, tail risks, derivatives