|

Can CTA outperform tail hedging strategies in 2022?

The current stock market crash has unfolded differently than the covid crash of 2020. This has implications for tail hedging strategies and CTA trading. What are the key differences between the two market crashes and how can this help us understand the risks??

In March of 2020, the stock market crash was caused by a sudden and unexpected event: the outbreak of the COVID-19 pandemic. This time around, the market is crashing due to a slow-moving, but inexorable, series of events: the winding down of the economic stimulus provided by the US government, the continued spread of the pandemic, and rising interest rates.  The crash is playing out over months, not a few weeks.

CTA Like slower crashes

As a result of the slower crash, systematic trend following advisors (CTA), which rely on computer models to identify and exploit market trends, have been outperforming tail hedging strategies that use options. But it is unclear whether this outperformance can be sustained.

Tail hedging strategies that employ options tend to prefer a very large and swift crash. For example, when the United States government shut down the economy in March of 2020, the market sold off close to 35% in a few weeks. This was a much deeper and swifter decline than what happened in 2022.

Tail hedging firms need large convex payouts from their out of the money put options to protect a larger position in traditional instruments like the SPX.  When a large number of investors need to sell to protect themselves from further losses usually implied volatility explodes to the upside and option prices can gain hundreds or even thousands of times the initial premium.  The covid crash produced put prices in the SPY etf that were 220 times what they were weeks earlier.

Implied Volatility has not risen to high levels.

.Unfortunately, the failure of implied volatility to spike means that the delta or the sensitivity of an option to the movement of the underlying asset has been more important.  Without the spike in implied volatility, the option price is gaining or losing value based on the the rise or decline of the asset.  The extra kicker of implied volatility is absent. 

Tail Risk Hedging firms are likely not happy with the performance in this decline.  Maybe some of the damage has been offset by monetizing as the market slides, but not enough to chip away at a drawdown this large.  Option prices remain are not cheap but not very expensive.  The best case scenario would be a large crash that compensates for the lackluster returns thus far.  If the market crashes further, hopefully, a large payoff will still take place.  Losing 20% would be made up with the tail hedges gaining 30 or 40 times their value.  This would limit a market decline of 40% to only 15%.  Still a significant victory.

CTA versus Tail Hedging with options
CTA

Eventually, the stock market crash will be over. Adding up the pluses of and minuses of tail hedging with options versus CTA to protect against market crashes can be done more accurately after the crash is done. My bet is tail hedging is still a superior method. I will have more to say in the future.

Best,

James

PS- If you like this post, please share. I would love you lots!

Similar Posts

Leave a Reply

Your email address will not be published.