4 Tail Risk Hedges For A Sudden Vol. Spike Or, ‘The Chevy Cavalier Trade’

With equity markets hitting highs everywhere but China, and with vol. suppressed across assets, you might be wondering if there’s any point to hedging.

Remember, in Aleksandar Kocic’s “state of exception” (i.e. in a world still governed by crisis-era policies), rebelling against the prevailing order is expensive, not to mention disheartening. Recall this from Kocic’s latest out last week:

Everyone is incentivized to participate in the reinforcement of the state of exception, while various forms of contestation of the power are inhibited. For example, attempts at shorting bonds are penalized by a steep curve, protection against volatile unwind is discouraged through wide vol calendars, negative carry etc. The fuzziness of its objectives, as seen through obfuscation of the objective function and metrics (a.k.a. moving the goalposts), has become a policy tool that undermines the power of a reality check. Collapse of short-dated volatility is a referendum on the near-term power of central banks, and softening of long-dated (and forward) vol represents first signs of acceptance of its extension and possible permanence.

Yes, “possible permanence” – or, the rather surreal possibility that there is no exit for central banks.

XIV target = ∞

On the bright side, tail hedges are cheap in this environment – even if they’re destined to expire worthless.

Yes, “cheap, but doomed to expire worthless” – kind of like a Chevy Cavalier.

Here’s Deutsche Bank:

Although implied volatility levels are low going into the summer, realized volatility has been rising slowly. There are many potential catalysts that could cause large re-pricing of risk almost instantaneously. These include political and geopolitical risk, positioning, and valuations starting to matter. European politics come back on the radar in the fall, the US is facing another debt ceiling deadline, and the longer we go without any US tax reform the more markets may become worried.

And here are some possible tail risk trades the bank says could come in handy on the off chance we do get the above-mentioned “instantaneous large re-pricing of risk.”

Delta-hedged 6M SPX 1×2 put spreads: A ‘low carry’ tail hedge that has performed extremely well in 2008. Effective to put on when timing of a large decline is uncertain as low cost of carry means it’s relatively easier to hold and/or roll over time. Our Asian colleagues recommended a similar structure on the HSCEI (18M 20-delta vs 10-delta) in their recent note on tail-risk hedging.

Buy EEM Dec-17 95%-80% put spreads. Equity weakness and dollar strength from a flight to safety in a correction will both affect EEM negatively. With a large portion of EEM’s weight in South Korea and China, any significant rise in geopolitical tensions in that part of the world will negatively impact EEM. Finally the ETF’s large exposure to the higher beta technology sector could see a large underperformance in the ETF in the event of a sell-off. The put spread price is attractive and is near the bottom of its 3-year range as implied vol levels are low.

Buy GLD Dec-17 125-135 call spread for ~$1. The metal has lost some luster recently (along with a weak USD) but should truly shine in the event of major geopolitical risk arising from North Korea and would likely do well in other risk-off scenarios. The trade can also benefit if real rates are expected to be lower. The maximum profit to cost ratio on the trade is 9x if spot were to rally through the 10-point spread.

Buy 6M SPY puts or put spreads. This is a liquid hedge instrument that should be easy to monetize during a market stress environment. SPY puts should also gain from an increase in implied vol and implied correlation accompanying a market decline. We suggest buying longer-dated out-of the-money puts with a view to closing or rolling 2-3M before expiry. While option activity is increasingly concentrated in short dated options, we prefer these to very short-dated trades as they are less dependent on getting the timing right.


Good luck…




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