Tail Risk Hedging: State of the Market

Journal of Financial Planning: September 2015


Jerry A. Miccolis, CFP®, CFA, FCAS, CERA, is a founding principal and the chief investment officer of Giralda Advisors (part of Montage Investments). He is co-author of Asset Allocation For Dummies®.

Gladys Chow, CIMA®, is managing director and a portfolio manager of Giralda Advisors. She has spent more than two decades managing money for regulated investment companies, foundations, trusts, family partnerships, and institutional, corporate, and individual clients.

In our work in risk-managed investing, one of our weapons is the design and management of a diversified suite of cost-effective “tail risk hedges”—i.e., devices that attempt to mitigate the impact of equity market downturns that are rare but potentially catastrophic. Accordingly, one of our priorities is the continual pursuit of better, cheaper, more effective ways to deliver downside portfolio protection. As part of this effort, we try to maintain close, collaborative relationships with key thought leaders in this area from other financial advisory and asset management firms, investment banks, and risk consultants of various types.

Earlier this year, we introduced a bit more formality into these ongoing efforts by issuing a request for proposal (RFP) to the aforementioned firms to see if there were any recent improvements in tail risk hedging that we may have overlooked. The result of our RFP process was, frankly, disappointing on the one hand but gratifying on the other; the potential improvements we uncovered were modestly incremental to our existing suite. However, by formally articulating our needs and diligently analyzing the varied responses, we were able to organize the current best thinking in this area in ways that were very useful to us. We would like to share our findings and the conceptual framework within which we organized them, in the hope that other advisers will find them useful as well.

To keep things simple, we will focus on hedging domestic large-cap equities, as represented by the S&P 500, and we will try to hold the discussion at a high level to avoid becoming mired in technical details.

Criteria and Organizing Framework

We should note that there are certain threshold criteria we have established for even considering a tail risk hedge. Briefly, a hedge should:

  1. Suddenly appreciate when equity markets suddenly decline, to a degree that meaningfully offsets the decline, and not give back that appreciation when equities recover;
  2. Have very low carrying cost during periods when protection turns out not to be needed; and
  3. Create minimal disruption to the rest of the portfolio.

Several common hedges do not make it past this screen. For example, equity put options are generally quite expensive and therefore tend to fail criterion No. 2. Also, unless one is adept at market-timing the exiting/monetization of the puts, they typically fail the latter part of criterion No. 1. Equity collars generally fail for similar reasons, though their cost (i.e., the sacrifice of upside potential) is more indirect than the explicit cost (i.e., the option premium) of puts. In fact, these three criteria eliminate the majority of commercially available hedging instruments. The discussion that follows includes only those hedging strategies that do meet our criteria.

There are many ways to categorize the myriad tail risk hedging strategies available in the market. One dimension could represent the source of the sudden appreciation that, in theory, would simultaneously accompany and therefore offset the sudden equity market decline. Two principal phenomena that exhibit such appreciation are equity market volatility and cross-asset-class correlation. Correlation is conceptually intriguing but still, in our view, not a practical reality yet. We concluded that volatility remains the single best source for the timely appreciation central to tail risk hedging. You can access and monetize volatility spikes in a variety of ways, and this variety represents a key element of our organizing framework.

Realized versus Implied Volatility

One major categorization of volatility is “realized” versus “implied.” Realized volatility is typically the standard deviation of the S&P 500 over some recent number of days or weeks. It is objective and backward-looking. Implied volatility is essentially what the market (buyers and sellers of equity options) believes equity volatility will be in the future.1 It is therefore subjective and forward-looking. Both versions of volatility can be accessed through investable products, and we believe that, if done cost-effectively, both should be accessed in a properly diversified mix.

The most cost-efficient way we have identified to gain exposure to realized volatility is to structure a trade—typically a swap with an investment bank—that provides you long exposure to realized equity volatility measured daily and short exposure to the same volatility measured weekly. Because it is far more common for “daily vol” to exceed “weekly vol” (a phenomenon driven by the typical mid-week changes in direction of the S&P 500), this trade has the potential to provide modest alpha in normal markets. In stressed equity markets, the same behavior (notably, the mid-week changes in direction) typically occurs, but things are now amplified, and the modest alpha becomes substantial. This is what makes this trade intriguing as a hedge.

The behavior just described is far from guaranteed and for that reason some banks are reluctant to categorize their version of this trade as a hedge in their own marketing material. We believe the potential to deliver hedge-like behavior is great enough that it should be included as a component of a hedging arsenal, but only as one part of a diversified suite of hedges.

Options versus Futures

With respect to implied volatility, there is no shortage of available investment vehicles that can provide you access. Typically, the instrument is a derivative. One category of such derivatives is based on options, another is based on futures. An equity put is probably the purest conceptual form of a tail risk hedge, but as we mentioned, it does not fare well against our criteria. A more cost-effective way to access similar hedge-like behavior can be to instead invest in VIX calls; VIX being the industry-standardized index of implied volatility.

The other relevant category of implied-volatility-based derivatives is VIX futures. We described VIX futures in the June 2012 Journal article, “Integrated Tail Risk Hedging: The Last Line of Defense in Investment Risk Management” (by Jerry Miccolis and Marina Goodman). The danger of holding a long position in VIX futures over periods when the equity market is behaving normally is that the value of the futures contract will decline significantly due to the “negative roll yield” described in our article. The best ways we have found to manage this decline is to (1) have both long and short exposure to these futures at different points on the “VIX futures curve”; (2) have a long exposure only when you have a reliable signal that equity markets are moving from normal to stressed status; or (3) some combination of (1) and (2).


While certain tail hedges are designed to be “always on” (for example, the realized-vol-based strategy described above), others may need to be switched on and off opportunistically to be cost-effective (for example, some of those based on VIX options and/or futures). This switching can be tactical at your own discretion, or strategic, based on well-defined signaling rules built into the hedge itself. Signal-based approaches introduce a new risk into the mix—the risk that your signal may prove to be unreliable. Signal risk can be managed by diversifying across strategies that employ different signals.

Trading with investment banks to access any hedges introduces counterparty risk, of course. So it is prudent to spread your exposure across several unaffiliated banks.

To recap, the dimensions of our framework are as follows:

  • Source of appreciation (realized vol; implied vol; correlation; other)
  • Delivery vehicle for implied vol (options; futures)
  • Timeliness (always-on; just-in-time)
  • Triggering mechanism for just-in-time strategies (tactical; signaled)
  • Basis of signal
  • Counterparty

Dynamic Diversification

Each individual tail risk hedge has its own vulnerability. This vulnerability can take the form of likely but far from guaranteed behavior of the realized-vol-based strategy we described earlier; or the signal risk inherent in any strategy that needs to be switched on and off; or some other form. Think of that vulnerability as the price to be paid for cost-effectiveness. Again, the key to managing the risk these vulnerabilities present is to try to diversify them away. The most effective way we have found to accomplish this diversification is to have our suite of hedges contain a representative from as many “cells” of our conceptual framework as practical. That is why we found the development of this framework so useful.

We believe the framework itself should not be static, but dynamic as the market for tail risk hedges evolves. We do not expect our time- and labor-intensive search for better, cheaper, more effective hedges to ever truly end; however we believe it’s critically important, because “risk assets,” such as equities, are an essential component of virtually every portfolio and their downside risk will be ever present. 

This column is for informational use only and is not intended to constitute legal, tax, or investment advice. Investment involves risk including potential loss of principal.


  1. Technically, it is the result of solving the Black Scholes options pricing formula "backwards" for expected volatility, the one element of the formula that cannot be directly observed, using current market prices for options as inputs.
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