PIMCO On Hedging: It Pays To Be Countercyclical

Tyler Durden's picture

Authored by Vineer Bhansali of PIMCO,

Tail Risk Hedging: It Pays to Be Countercyclical

It is a well-known phenomenon that quiet markets, low volatility and a lack of visible risks on the horizon can lead to complacence and increasingly dangerous, leveraged positions. In doing so, these market conditions set the stage for the next cycle of deleveraging and losses. What has also become apparent is a predictable behavioral response to this cycle.

When the markets experience large losses, tail risk hedging comes back into fashion, leading to an old-fashioned surge in demand that drives up volatilities across markets. This in turn reduces the overall effectiveness of naïve hedges, and means one has to be smart about when and where to spend hedging premiums.

On the other hand, when markets are quiet, investors can quickly forget the pain suffered during prior crises, and may choose to eliminate the cost of tail hedging, or even more dangerously become sellers of tail hedges.

While no one really knows whether the future is going to result in more or less risk for markets, a quick look at the valuation levels for even the most vanilla of tail hedges shows us that we are back to the inexpensive levels we last saw prior to the financial crisis.

The table below is a historical comparison for direct tail risk hedges using SPX index put options going back to 2007: The conclusion is that even though skew (or difference in volatility between at-the-money and out-of-the-money tail hedges) is high, the cost of hedging in absolute terms is back to pre-crisis lows.


Investors should consider taking this opportunity to reload their hedges as soon as they can.

  • The first column in the table is the year (using the same day eliminates any seasonal issues).
  • The second column is the S&P 500 index level.
  • The third column is the VIX (which is basically the weighted average of the whole volatility skew surface for short expiry options), a widely followed indicator of risk.
  • In the fourth column we have the one-year, 25% out-of-the-money (OTM) volatility for a 25% OTM SPX put. We use 25% out-of-the-money volatility because a 15% OTM attachment point for a 60/40 (stocks/bonds) portfolio translates to a 25% direct SPX option.
  • The next column is the 25% OTM strike price of an SPX option, currently at 1100.
  • The skew to VIX, the sixth column, is still pretty high compared to the levels we saw in 2007 when the SPX was last near its current level (a 4% excess crash premium if you compare the 7% skew then to the 11% skew now).
  • Finally, the next column shows the price of the 25% out-of-the-money SPX put option is currently at 1.42%, a post-crisis low.

When we scale this pricing for the 60/40 portfolio we get a “full-coverage” premium for what would generally be considered a naïve tail hedge of only 85 basis points (bps). In other words, a 60/40 portfolio can be hedged so there should not be downside beyond 15% for 85 bps for a one-year horizon.

This situation is not likely to last long. This is comparable to 1/15/2008, right before the crisis – although the volatility skew was flatter, out-of-the-money volatility was at roughly the same absolute level as it is today, so both the cost of the OTM put and the delta of the OTM hedge were roughly the same as they are today. For many investors, it paid to have tail hedges then. If investors believe we are still investing in a dangerous, potentially even more dangerous, environment, they should consider hedging.

Our discussion does not need to stop with buying volatility. There are many other markets that typically benefit from a falling VIX. Many credit markets have been direct beneficiaries of the belief in seemingly lower tail risks in equity markets, and could also end up suffering if there is a re-emergence of widespread fear of, and upward repricing of, these tails. The story runs pretty much in parallel for indirect hedges as well.

[ZH - perhaps that is what triggered some 'cheap' tail-risk hedging today?]


We believe that tail hedging is not just a trade, but an asset allocation decision for robust portfolio construction. In this light, today’s valuation levels make it easy to be countercyclical and add to tail hedges. Buy them at current attractive valuations.


[ZH: Valuations? - h/t @Not_Jim_Cramer]

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Nihilarian's picture

VIX contango = go long. VIX Backwardation = go short. Well, at least that what I learned from Artemis Capital. http://youtu.be/xlKWdd_DhW0

knukles's picture

If it's PIMCO it's got to be propaganda


(Professional bullshit high tech drivel artiste deluxe on a closed simulations course, don't try this at home or you'll have your ass handed to you.  Full disclosure:  I ain't got a pipeline into Washington nor get lots of free lunches paid by the brokers paid by client commissions.)

disabledvet's picture

i agree. "Wall Street ain't in Los Angeles" for a reason...and that's because they're ALWAYS long equities in New York. Could this whole market shit the bed? Absolutely. Could it go up 40% in the next three months? Yep. Hmmm. I wonder which side of the trade Wall Street is on? Anywho treasuries have been rock stars for so long it's amazing the complacency OVER THERE actually. Imagine if the Fed just decided to normalize! But i do agree "that's too much to ask" when you've got a war to finance...one which will be fought "in the barracks" it would appear. (and hooray for that i might add.) i've really never seen anything quite like this equity run...and while i fully expect to be wrong any day now i REALLY find it strange that i'm not changing my mind (bullish) about it. http://www.youtube.com/watch?v=Zae70abcW7Q

jldpc's picture

How about someone who knows how to do this gives us a primer on say $50,000 invested with a long delta (SPY) of 1500. what product/instrument should we buy/sell to use the vix (dated options) to hedge a loss greater than 15% for a period of 6 months. THX.

Everybodys All American's picture

Why hedge? Just sell your long positions. I see no productive reason to hold anything that's trading at five year highs on this economic backdrop with Federal debt growing nearly exponentially under Obama.

SAT 800's picture

Yes; for heaven's sake do sell your positions. this market is ripe; it's time for it to deflate; there's no reason to own any common stocks. I was willing to buy BAC at $5.00; and F at 10$, and I made a nice proift  on that; but that's because the herd was all paicked in the other direction; right now "mindless enthusiasm" is the order of the day; and you certainly don't want to be in the market. 

SAT 800's picture

Simply short the ES contract on the CME and roll it over as necessary if it's going in your direction for some time; you really should know something at least about futures tradding; but I have never seen any reason to do anything else but buy or sell the futures contract; it's very straightforward; you need a stop loss, of course, in case you guessed wrong about hte top; and you need to wait long enough to allow for a substantial change, and a substantial profit, to accrue. If you sell two ES contracts short, you add $100 to your account every point the average drops; and this is a kind of nice process, especially if it falls all the way back to womewhere that makes sense; like 1250. This would take months of course. The conversation about options, the sales pitch, as it were, sounds okay; but on close examination they really don't do anything for you that futures contracts don't do. A stop loss order really does limit loss; (the usual selling point for options), and the commissions and "friction", are very very much in favor of a futures contract.

long-shorty's picture

trading is so much more fun when options are reasonably priced

jcaz's picture

....And that's why you sell them... 

Beautiful how options work- flavor for everyone if you can figure it out.....

NoDebt's picture

Note to equity mutual fund managers...... maybe buy some protection right about now and save some of your clients money when this insane uptrend turns down.  You already charge too much, so maybe put out the Benson & Hedges, put your game face on and do something useful to protect against downside while the getting is good and cheap.  Waddayasay?  Have just the slightest bit of caring about your (little) clients money.  Just this once?

bnbdnb's picture

The last two times the market hit such low employee to dow points ratios, we experienced a 30% correction over the next couple years. (now near 11)

MyBrothersKeeper's picture

That's all fine and good but when the government(s) are willing to Star Trek (go where no banker has gone before) in order to maintain the fallacy of an improving economic situation, it should be obvious that controlling volatility is a key component. Tail risk hedges are good when: 1) the event is completely unexpected; and 2) When your hedge is tied to something at least semi transparent. Vix hedges are far from transparent and certainly open to manipulation....if not fraudulently then certainly via propoganda from the governments and mainstream media which, economically speaking, have turned into a civilized world's version of Baghdad Bob propping up the Potekim Village.

My advice:  Have an exit strategy/sell discipline and stick to it.  For stocks/ETF's use trailing sell/stops.  There are opportunities well before the crap hits the fan that you can use selectively to short but since most investors...especially at institutional/401k level don't have these available...have an exit strategy.  If it turns out to be a false alarm you will at least sleep better.

I also find it interesting that most pundits say you can't hold VIX ETF's because you will always get killed.  Well if you bought and held the XIV ETF since Thanksgiving 2011 you'd be up about 350% and counting....of course that was before we realized the Star Trek bankers would go to such extremes to suppress volatility. These days the VIX is nothing more than a signal to central bankers and their media schills that it's time to go out and spread some good news (aka bullshit). The VIX retreats and they wait for the next signal. 

Son of Loki's picture

Odd how Al Gore sold his options a few days before the plunge....strange.

rguptatx's picture

Maybe we could ask contributors to post a one paragraph excerpt, and a link to the 20-minutes of reading-required article, and enforce it as well? Anyone else down with that?

jcaz's picture

Even more odd is how he'll wind up paying less than 20% tax on his gains......

MachineMan's picture

Cramer says buy!

GubbermintWorker's picture

Sell! And buy physical gold and silver.

SAT 800's picture

http://www.periodicvideos.com/videos/feature_gold_bullion.htm  This seems like a good place to post this; it's a rather lovely video, about a day out on the part of chemistry prof. and his video maker who run a series on the Elements on you tube. This particular video is their trip to the Gold Bullion vaults of the Bank of England. It's sort of gold pornography, I suppose. Also, as you can see if you were to buy some gold at bullionvault.com, for instance, which makes it's purchases as a member of the London Bullion Market, that there is rather a conspicuous amount of real, very real, gold that they can and do buy and this might make you feel a little less paranoid.  At any rate, enjoy.

Rottenclam's picture

Cool little video.  Thanks for the link.  That professor seems like quite a character!

SAT 800's picture

also; since we're discussing being countercyclical; also known as contrarian; here is possibly the world's most under-priced working gold mine for those of you who are interested in this sort of thing. You can read all about the mine itself and it's operations; they have their own website which I'm sure you can find wiht google. the share price was much higher a couple of years ago; and yes, it is a working gold mine in a very stable country with a good labor force; they ship bars every month; essentially as this price, determined by the irrational enthusiamss of the stock market; you're buying gold that's still in the ground, and they know it's there alright, for something like 175$/oz.http://www.asx.com.au/asx/research/companyInfo.do?by=asxCode&asxCode=CTO  So, once again, this is just the stock info. page; but the mine itself does have its own website, and it's very interesting. Cheers.

SAT 800's picture

And finally; here is the actual website for the mine mentioned above;http://www.citigold.com/  And, no I don't get paid for helping them out; I wish I did. I don't ordinarily advise anyone to buy any kind of stock; but this is a special case; the price is ridiculous; "the Market" in its' infinite wisdom has just creamed Aussie Mining shares; this makes not sense at all, but it's there to take advantage of if you wish.

knowless's picture

terrorist fist-jab, remember that one? they caught osama. downvote this post.

Iam Yue2's picture

Anyone seen Hugh Hendry?