As part of my work at Mutiny Fund, a deep area of interest for me is tail hedging (sometimes referred to as long volatility). I’ve read a good chunk of books on the subject and put this together as a primer of where to start.
The books are roughly in the order that I would read them, starting with a more non-technical and philosophical slant then gradually getting more technical and complex.
If you read through all of these, you will be in the top 1% of investors in the world in terms of an understanding of tail hedging.
The Dao of Capital: Austrian Investing in a Distorted World– Mark Spitznagel
Mark Spitznagel is a former partner to Nassim Taleb and runs Universa, one of the largest tail risk hedge funds in the world.
The first 80% of this book is devoted to how trees develop, military strategy and economic thought. These finally tie into the investing thesis in the last 20% of the book. I would say that it is much more an introduction to Austrian economics and what that implies about the philosophy of tail risk hedging than a how-to investing book. This makes it a good starting point that’s very approachable regardless of investing experience though perhaps unnecessary to the more experience hedger.
The book is centered around the Austrian notion of time preference, that most investors have high time preference meaning they want returns now and take on too much to get it. The long term investor that is willing to use tail risk hedging strategies can outperform by having low time preference and outlasting those chasing short term returns.
The Allegory of the Hawk and the Serpent – Artemis Capital Management
Though not technically a book, I would be remiss not to include this paper along with the other papers on long volatility and tail risk from Chris Cole at Artemis Capital Management.
The Allegory of the Hawk and the Serpent is a philosophic map to understanding the generational cycle of wealth creation, destruction, and rebirth to guide your investment decisions and protect your prosperity.
The paper starts by asking you to imagine that you have the opportunity to grant your family great wealth and prosperity for 100 years subject to one important choice. You must decide what assets to invest in and maintain that allocation for an entire century without ever changing it. The future of your children’s children depends on your choice. What do you do?
A key element is some form of tail risk hedging, using defensive assets such as long volatility, commodity trend and gold to improve the risk-adjusted performance of the portfolio. Cole uses almost 100 years of data to try and determine the optimal long-term portfolio. I wrote a full summary of the paper here.
Option Volatility & Pricing: Advanced Trading Strategies and Techniques – Sheldon Natenberg
If you want to tail hedge, you are almost certainly going to be using options in some capacity. Natenberg’s Option Volatility and Pricing is the most recommended introduction to options from the best traders I’ve spoken with.
The book reads more or less like a textbook so don’t expect a breezy read, but if you read closely, you will leave with a pretty good intuition and understanding around the core theory of options pricing as well as different ways to structure options trades as well as the terminology to understand other books on this list.
In particular, the chapter on option Greeks (delta, gamma, vega and theta) is an invaluable resource.
The Second Leg Down: Strategies for Profiting after a Market Sell-Off (The Wiley Finance Series) – Hari P. Krishnan
Hari Krishnan’s The Second Leg Down is perhaps my favorite “advanced” book on hedging the tails. The book goes through the most popular and effective strategies for tail hedging providing a detailed historical analysis of each as well as looking at different ways to implement them.
The central insight is that what matters is the repricing of risk. Most market participants when they buy 3-month puts -20% down do so because they think the puts will finish in the money. Hari shows that what really matters is the repricing of risk.
If one month into the contract, the market has had a sharp 10% sell off, then those options have already appreciated greatly, even if the market never hits the 20% down market. As a result, most hedgers buy too close to the money and end up losing.
TAIL RISK HEDGING: Creating Robust Portfolios for Volatile Markets – Vineer Bhansali
Vineer Bhansali was a veteran of PIMCO and has extensive experience in tail risk hedging.
He shares what he learns in Tail Risk Hedging in a rigorous, but clear way.
This book tells you how to prepare, how to calculate how much being prepared will likely cost — the insurance premium — and why you should do it anyway. He also goes into how to get the most bang for your hedging buck with specific strategies.
He explains how a chaotic market can be actually a blessing: when the market is crashing and everyone else is panicked or getting margin called, wouldn’t it be nice to be sitting on a nice little pile of cash from your tail hedge?
Dynamic Hedging: Managing Vanilla and Exotic Options – Nassim Nicholas Taleb
Nassim Taleb is now famous as something of a Twitter personality and author of more mainstream books such as the Black Swan and Antifragile.
However, he started his career as an options trader and ran a hedge fund, Empirica, that focused on tail hedging for institutional investors.
Dynamic Hedging is a strong advanced text which goes through many nuanced topics. For example, he makes some good points on managing option greeks. Some chapters I really enjoyed which are hugely important in practice that you don’t learn in any classroom: soft American options, discrete delta vs continuous delta, fungibility.
If you’re interested in learning more about tail risking hedging, you may enjoy some of the research and podcasts at Mutiny Fund where I work on helping investors build more resilient portfolios by attempting to add a form of ‘antifragility’ or ‘crisis alpha’ that is intended to achieve large gains in times of high volatility such as 2001 and 2008.
Last Updated on October 28, 2020 by Taylor Pearson