Tail Risk Hedging: The Search for Cheap Options

The Journal of Portfolio Management, November 2023, 50 (1) 106-119 DOI: 10.3905/jpm.2023.1.539

Posted: 10 Mar 2023

See all articles by Poh Ling Neo

Poh Ling Neo

Singapore University of Social Sciences

Chyng Wen Tee

Singapore Management University - Lee Kong Chian School of Business

Date Written: January 3, 2023

Abstract

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

Suggested Citation

Neo, Poh Ling and Tee, Chyng Wen, Tail Risk Hedging: The Search for Cheap Options (January 3, 2023). The Journal of Portfolio Management, November 2023, 50 (1) 106-119 DOI: 10.3905/jpm.2023.1.539, Available at SSRN: https://ssrn.com/abstract=4378071 or http://dx.doi.org/10.2139/ssrn.4378071

Poh Ling Neo

Singapore University of Social Sciences ( email )

461 Clementi Road
599491
Singapore

Chyng Wen Tee (Contact Author)

Singapore Management University - Lee Kong Chian School of Business ( email )

50 Stamford Road
Singapore, 178899
Singapore

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