INSIGHTS

Stefano Sciacca

Wed, Mar 18


How To Protect Your Portfolio From Fat Tail Events & Black Swans

Risk management has always played a crucial role when building a cross-asset portfolio. However, most investors believe risk management is a powerful tool to limit potential losses or downside on the portfolio’s performance. The truth is that risk management should actually be seen as a way to generate extra profit in periods of market uncertainty and turmoil.

 

Within the intrinsic market variability, what technicians define standard deviation or historic volatility, very few people amongst the “bear” community seem to pay particular attention to fat tails and black swans events. These types of events, as defined by the infamous finance professor Nassim Taleb, are extremely unlikely and very rare negative events which impact a specific economy (or portfolio if contextualised within the investment universe) as an exogenous shock, something that is not foreseeable or predictable anyhow.

 

One recent example has been the Lemhan Brothers’ collapse as never happened in history that such a big and influential investment bank would let fail, distressing the worldwide financial communities and causing a huge spike in systemic risk. In mathematical terms, given that we gauge the stock market variability as the distance between periodic returns and their mean (standard deviation), a black swan or fat tail event (referred to extremely unlikely event placed at the bottom of the normal distribution tails) has an outcome which shakes the stock market by more than 2 times its standard deviation (recognised from economics and financiers as the upper and lower band of a “normal” stock market distribution).

 

What we have seen in the Great Financial Crisis and what we are seeing right now can be categorized as Black Swans from both a qualitative and quantitative perspective. Qualitative because the COVID-19 impact was and still remains unpredictable, quantitative because the following volatility is way above the “normal” level.

 

The role of a responsible portfolio manager (or an investor) requires to also allocate a small amount of the money under management in tools and securities whose task is to minimise the impact of such disruptive events. As a consequence, the hedging positions will be massively loss-making when the economy and the stock market thrive, whilst will be more than offsetting the portfolio’s losses once a downturn in the economy and, consequently, in the stock market might start.

 

There are several securities and asset classes that can be used for this specific purpose. Options are by far some the most preferred by investors given their fair live pricing, their market depth, their liquidity and their ease to be widely understood by the investment community. Once all the variables affecting the options pricing are clearly understood, any investor can hedge or speculate through them. Options are extremely powerful securities whose value derives from the spot price of their respective underlying asset (i.e. Stock, Index, Bonds, FX). They can be exercised at maturity only (European) or before (American, Bermudan). The trigger that actionate the options, and lifts their value up, is the Strike Price of the underlying asset, a fixed price where the spot price has to be compared to understand if the option is in the money, out of the money or at the money (spot price=strike price).

 

Without getting too much into the technicalities, options give investors an opportunity to generate alpha, and hedge, when the underlying asset changes in value without actually holding it. In fact, any option gives the right to buy (Call) or sell (Put) a specific underlying at a specific fixed price (Strike Price) and Maturity (Expiry date). Given that in finance there is no such a thing as a “free lunch”, any investor has to pay for the privilege of potentially gaining (and not losing as the out of the money option would not be exercised) from an asset not held. Hence, they have to pay for the premium.

 

The premium of an option is the price that any investor has to pay to have the right to buy/sell any specific related underlying asset. The more spot price of such underlying approaches the trigger (strike price) and the more likely the option is to get in the money. If this happens, the premium of the option will appreciate and the holder will start seeing massive gains. Furthermore, given that the options have many intrinsic variables used to derive their values, such as time, interest rate, market volatility, sensitivity to market moves etc etc, the appreciation or depreciation of the premium is not linear and is not proportional to the related underlying asset change in price.

 

During this recent market turmoil caused by both a price war on crude oil and the COVID-19 panic, Options are thriving thanks to the big swings that the market has been experiencing over the last three weeks. The “fear” Index, also called VIX or Volatility Index, gives a proxy of the 30-60-90 days implied volatility of each constituent of the SP500. When any investor buys an option he is automatically long “volatility” as he buys the likelihood of whatever underlying asset to move upwards (Call) or downwards (Put). The result has been a general appreciation of options and especially of Put options on the SP500, purchased to bet on the market shortfall. Volatility (VIX) call options have also gained a decent return as they are negatively correlated to the SP500, hence they are more likely to be in the money the the US stock market collapses rather than rallying.

 

Kylin Prime Capital decided to implement an option strategy to be long volatility on the SP500. The strategy is called Strangle and consists in buying 2 options, one call and one put, with different strike price and maturity date. Specifically, the call option needs a higher strike price than the put option. The price of the strategy equals the sum of the two premiums, while the potential positive payoff implies a 10+ percent move upwards on downwards.

 

 

We decided to launch this strategy after weeks and months of market stagnation, frustrated by steady appreciation of the SP500 fragmented by quick and small price correction always promptly rebounded, amid economic global slowdown especially in the manufacturing sector. We expected a big market meltdown to hit the global economies, while timing was of course uncertain and confidence on the market was so high that we decided anyway to capture any upside of it. When the COVID-19 outbreak hit Europe and fear started to panic investors supported by supply-chain disruption, slowdown in exports, FX devaluations, deflation, deteriorating consumer spending, falling airline companies and so on, the stock market finally started to break lower. We were prepared and we are capturing any downfall.

 

Any investor should be prepared for the worst at any time, even when optimism spreads around the investment community and complacency around the markets seems unstoppable.

 

We will see where the market is headed and how the central banks and respective governments will handle the issue both from a healthcare and economic point of view.


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