April 2, 2022
hey, hey
A few weeks ago, I saw an interesting statistic on a football player from the Chicago Bears and I realized that it could teach a lesson for tail hedgers. I know not everyone is interested in American football, but being from Chicago, football is something that I cannot ignore. Hopefully, using sports as a metaphor will be a little more exciting than the usual tail hedge terminology. Which, quite frankly, is kind of boring.
Khalil Mack, a defensive end, was drafted in 2014 by the Oakland Raiders. He played four seasons of outstanding football and became a well-respected player.
In 2018, the hapless Chicago Bears decided to sign Mack to a much larger contract. Unfortunately, they ended up not getting much in return.
What mistake did the Chicago Bears make? They overpaid for the same performance! Mr Mack did not exceed his previous level of play in Oakland.
I am not trying to play Monday morning quarterback. Selecting the proper players and building a winning team is not easy, unless you are the New England Patriots. However, perhaps the Bears might have asked themselves whether paying five times the old contract was worth it.
Overpaying for tail hedges or any option for that matter can hurt just like overpaying for defensive ends. That is why we are trying to hedge when prices are cheap and no one is demanding our hedges.
Rising prices for protection do not guarantee that you will lose money, you just have less room for error and need future performance to exceed expectations. If Khalil Mack exceeded his performance with the Raiders while he was with the Bears, his contract would have looked less ridiculous.
Buying a tail option for a moderately high price might turn out ok if the market has a large crash. The Expectation of future performance would be closer to realized performance. Similar to realized versus implied volatility. A subject for another post!
Price always matters. The cure can be worse than the disease. For the Chicago Bears, passing on Mack might have cost them nothing. Passing on an expensive hedge because it is too late might make more sense than overpaying.
Best,
James
PS- The Bears never made the playoffs with Mack. Two losses in the wildcard round.
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