The fat-tail risk in various financial markets is very obvious. Readers who want to learn more can read "Fat Tail Effect" by Master Ta. In fact, the soul-searching question that option sellers need to solve for long-term stable returns is what to do when they encounter tail risk? What will happen if the investment portfolio draws down? Is there a risk of liquidation?
1. How to define tail risk
Tail risk refers to the risk of extreme returns in a portfolio. The returns in the financial market are widely considered to be thick-tailed distributions. The thicker the tail, the greater the probability of extreme returns. (pic source: CITIC Futures & Wind)
The risk framework of modern portfolio theory is based on the assumption that logarithmic returns follow a normal distribution. But in fact, the distribution of asset returns deviates from the normal distribution in reality, and the historical frequency of extreme returns is much higher than the prediction of the normal distribution. In particular, in recent years, risk events in the securities market have occurred frequently, and the frequency of sharp declines in asset prices is significantly higher than expected by the normal distribution. (See: "Fat Tail Effect") It can be seen that compared with the normal distribution, all mainstream indexes of US stocks and A shares have greater tail risks. (Take the Shanghai Stock Exchange as an example, pic source: CITIC Securities)
2. How to prevent tail risk?
①【Asset allocation concept】
My overall asset allocation philosophy comes from several books by Mr. David Swensen. If you are interested, you can read them.
Allocate multiple assets with low correlation or reduce the weight of risky assets to prevent the impact of sudden risks of a single asset on the entire portfolio. This idea should be very clear to readers who have read my previous articles.
My current focus markets: A-shares, Hong Kong stocks, Web3, and US stock ETFs. Investment targets: broad-based and narrow-based ETFs, block trading or private placement, convertible bond arbitrage, quantitative public and private placement index increase, self-trading options, etc.
In general, asset allocation can be balanced once every six months, which takes less effort. You should study or learn each type of asset in depth for at least one year (no more than one new investment strategy should be mastered each year to ensure depth).
②【Low volatility target】
From the perspective of selecting the target, volatility indicators are taken as the key considerations. In the past, as an institutional investor, some strategies such as CPPI and TIPP may be used. In fact, as an individual investor, I personally don’t think they are very useful when managing assets. You only need to set a fixed combination strategy (CM) according to the year. In fact, it is a bit like a deformed version of the Merrill Lynch clock. Because the Merrill Lynch clock is old and its underlying logic has long-term validity, but the changes in the financial market have accelerated in the past 20 years. In addition, each investor has a different understanding of the target and investment style. I will choose according to my own cognition and preference. The details can be expanded later.
③ Option tail protection
Common option strategies that can be used to guard against tail risks in the stock market include: Buy put strategy, collar strategy, put-side reverse proportional spread strategy and risk reversal strategy.
Collar strategy:
Compared with the simple buy put option strategy, its construction method is to hold the underlying asset while not only buying out-of-the-money puts but also selling out-of-the-money calls. The characteristic of the Collar strategy is that when the underlying asset rises or falls slightly, the portfolio profit and loss is close to the underlying asset, while when the underlying asset rises or falls sharply, the strategy cuts the profit and loss.
Option Put-side Reverse Proportional Spread Strategy:
It means buying a certain number of option contracts while selling different numbers of option contracts with the same underlying and same expiration date but different exercise prices. Put ratio spread strategy, both buying and selling are put option contracts. For example, buy put options with low exercise price at a ratio of 3 to 2, and sell put options with high exercise price at the same time.
Option risk reversal strategy:
Similar to the collar strategy, both buy put contracts and sell call contracts at the same time. The difference is that the reversal strategy requires the execution price of the put and call contracts to be the same. The option reversal strategy is a classic strategy used for spot arbitrage. When the call-call parity relationship is not satisfied for the virtual underlying synthesized by the call put option, the opportunity for spot arbitrage can be obtained. Because this strategy can synthesize virtual underlyings, its expiration profit and loss structure consistent with stock index futures can also be used to hedge the risk of the underlying falling.
Although traditional stock strategies and asset allocation can reduce the risk of a portfolio, it is difficult to achieve refined management of tail risks, and the allocation of low-risk assets will reduce the overall return of the portfolio.
Conclusion
Asset allocation can reduce the impact of sudden risks of a single asset on the entire portfolio. Corresponding stock strategies can also reduce the risk level of the portfolio, while option hedging can effectively and accurately prevent tail risks.
Although the use of option hedging strategies requires continuous costs, since it can finely control the tail risk of the portfolio, in the long run, for markets with greater volatility, option hedging strategies can significantly improve the performance of the portfolio.
In the subsequent option strategy area, we will further study some dynamic tail risk management methods. This article is more focused on ex ante risk control.
