Tail Risk Hedging: The Search for Cheap Options
24 Pages Posted: 10 Mar 2023
Date Written: January 3, 2023
We find that a simple heuristic of sorting liquid equity options by dollar price to construct a portfolio of cheap put options leads to a surprisingly robust tail risk hedge - the superior performance holds even when compared against advanced empirical option strategies. Further investigation reveals the asymmetry in market correlation under different market conditions as the mechanism of this robust hedging performance. The correlation spike accompanying tail risk events leads to most of these options moving into the money, compensating the losses incurred on a broad-base equity index holding. During normal market conditions, these options benefit from the diversification effect due to a lower market correlation, thus mitigating the portfolio drag effect.
Keywords: tail risk, portfolio insurance, risk management, portfolio management, hedging, option markets, index options, volatility risk premium
JEL Classification: G11
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