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What is the Tail Risk Hedge? Wisdom Every Stock and Option Trader Should Know - YouTube
Channel: Stocks And Coffee With Didi
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In this short video, I m going to briefly
discuss the tail risk hedge and some of its
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application when trading stocks and options.
The tail risk hedge is a critically important
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topic for anyone who s portfolio has a directional
bias in the stock market. This includes almost
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every stock owner in the world. There are
two parts to understanding the tail risk hedge.
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First and foremost, we have to define and
explain what exactly is tail-risk? And only
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after than can we talk about hedging or protecting
your portfolio from this type of risk. Before
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we jump into it, if you enjoy this content,
please consider supporting this channel by
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smashing the subscribe and like buttons.
The Tail in tail risk refers to the end parts
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of a distribution curve. What does the tail
tell us exactly? In basic terms, the tail
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communicates the likelihood of a 3 standard
deviation move in a given data set. Tails
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can look different depending on the distribution
we are looking at. Nassim Taleb has done a
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tremendous amount of work in this area including
the serious shortcoming of assuming gaussian
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or normal distribution when it comes to trading
stocks and options.
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For the sake of simplicity in this video,
we ll assume stock movement distributes in
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a relatively gaussian fashion. The normal
or gaussian distribution posits that the majority
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of data points will involve minor deviations
from the mean, falling somewhere in the middle
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of a curve, while on rare occasion the data
will experience massive deviation from the
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mean. These massive deviations occur in the
tails of the distribution. So how do we apply
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this to trading?
The normal distribution tells us that the
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prototypical long stock portfolio will experience
on the vast majority of days slight changes
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in profit and loss. However, the distribution
also tells us that somewhat infrequently,
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the portfolio will experience massive upside
payouts or downside losses. These moves constitute
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the tails of the portfolio. They are the rare
multi-standard deviation moves from the mean.
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To the upside, a long portfolio has a riskless
tail, which means that if the market were
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to make an outsized move to the upside, the
portfolio would experience profit or at least
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no loss. However, the long portfolio also
has a tail to the downside. On the downside,
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a massive move would constitute a devastating
loss to the portfolio. This is what we call
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portfolio tail risk.
Now that we understand theoretical tail risk,
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take a moment to think about your portfolio
and where your tail risk lies. For example,
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if you own a retirement account tied to the
stock and bond market, your tail risk is on
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the downside and you might have substantial
tail risk.
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One of the ways to address tail risk while
maintaining a long position in the market
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is to purchase a hedge or insurance. This
should be reminiscent of purchasing insurance
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for your life, your home or your car. That
being said, students of black swan risk and
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financial markets might argue that stock portfolio
insurance is perhaps the most important insurance
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you can possibly purchase because the likelihood
crashes in the market are substantially greater
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and more devasting than the risks to other
assets in your life. In other words, circling
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back to our earlier discussion, the tails
in the stock market are fatter than you might
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in other walks of life.
For most trader s, a tail risk hedge can be
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done by purchasing far out of the money put
options on your asset or a highly correlated
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asset. Knowing which Put to purchase and how
much of your portfolio to use for hedging
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is complicated business and takes practice
to do well. That being said, purchasing a
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put option is an extremely powerful device
for protecting yourself to the downside. Long
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Puts have a convex payoff structure which
means that when stocks begin to fall, Puts
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can rapidly increase in value becoming many
multiples of their initial purchase price
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and ultimately saving your portfolio from
catastrophic, apocalyptic, devastation, and
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ruin. In another video, I will explore in
greater depth the decision making process
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that I go through when considering when to
purchase Puts and which Puts to include in
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my portfolio.
Thank you so much for watching! If you enjoyed
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this video please support the channel by smashing
the subscribe and like buttons!
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