Lots of tail hedge articles these days. I feel many miss the point. They keep studying returns as if they add with each other through time. They don’t. The math of lose 3% in 9 calm years, make 25% in the one volatile year = -5% return is meaningless.
The average through time is meaningless because investment returns don’t ADD. They COMPOUND.
A tail hedge that reduce the average return of a portfolio (as a tail hedge often does) but reduces the portfolio variance by more than twice as much, leads to higher geometric returns.
A tail hedge that reduce the average return of a portfolio (as a tail hedge often does) but reduces the portfolio variance by more than twice as much, leads to higher geometric returns.
Now is this really complicated and difficult to get right with options based tail risk hedges? Yes. There are so many ways to implement it and returns are skewed and convex. And if you don’t understand why tail hedges are useful, you could easily butcher the implementation.
Does this mean all tail hedges work? No certainly not. I personally haven’t figured out how to implement volatility based hedges confidently in my own system myself, but have seen others take their tail product and theoretically mix it with mine for great results.
But the rational for using tail hedge always evolves around: down 35%, up 35% is a 12% loss (1.35*0.65=0.88). But 10% up and 10% down is only a 1% loss. The relationship between volatility and “wasted return” is convex. It pays to smooth out returns
breakingthemarket.com/the-road-not-t…
breakingthemarket.com/the-road-not-t…
Tail hedges harvests that convexity.
A proper evaluation of tail hedges would compare how the asset changes a portfolio's average return against its reduction in portfolio variance. Simply looking at the tail hedge's return itself misses half equation.
A proper evaluation of tail hedges would compare how the asset changes a portfolio's average return against its reduction in portfolio variance. Simply looking at the tail hedge's return itself misses half equation.
It should say -2% return.
