Equity Tail Protection Strategies Before, During, and After COVID

Abstract

Tail risk is usually an important consideration for investors, and a desire to limit catastrophic loss has led to significant interest in protection strategies. Across four distinct market periods surrounding the COVID pandemic, we explore three common tail-risk mitigation strategies (1) a long volatility protection strategy using options; (2) a put protection strategy and (3) a long VIX futures protection strategy. Our analysis found three main themes emerge. First, hedging is expensive. Second, the variable equity exposure embedded in option strategies is a source of risk and path dependence. Finally, a hedger’s decision on whether to delta-hedge their option exposure to isolate the option convexity, or to maintain an unhedged position, materially impacts performance in non-forecastable ways. We also acknowledge the number of well-reasoned arguments both in favor and against implementing tail-risk hedging strategies. We find that the dispersion of outcomes across only the few strategies explored in this article is notable, and that there is likely no easy solution for tail-risk hedging. Those who implement protection strategies should plan for the possibility that their hedges make things worse in times of stress.

Keywords: Options, Portfolio Protection, Tail Hedging, Tail Protection, Tail Risk Hedging, Put Protection, Long Volatility, VIX Futures, Volatility Risk Premium

JEL Classification: G00, G10, G11, G12, G13