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Threads to take to your mind off things, something more interesting I hope. Part 1.
Tail risk, done cleanly, is pure convexity and no beta. You’re looking for cheap optionality. 2 ways this can arise. First the option looks underpriced compared to payoffs in a few realistic scenarios. Second there are extreme scenarios that look more realistic than usual
Example of the first is just usual relative value trading: vol and skew is sometimes just cheaper than usual
Example of the second is when positioning looks skewed and skewed to weak hands: small moves will become large ones as those hands hit stop losses or are pushed
XIV blowup is an example of both being present together: SPX skew was low as calls got bid in Jan18. Then on a small move weak SPX longs cut, and smart vol funds pushed VIX to the tipping point
The importance of the second situation is much higher for convex trades like a tail hedge than for most delta1 positions
This means it’s vital to understand who else is buying/selling the tail. You want to be buying when nobody else is.
This makes tail risk trading a minority game. These are fun economic situations and mathematical toys. Progress has been made solving simple games. This isn’t like game theory where only a few play, this has many players and we care about their aggregate behaviour
So if you want to look in depth at tail risk and learn something fun too, take a look at minority games
Can recommend
