Tail Risk Hedging Using Option Signals and Bond ETFs

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Tail risk hedging plays a critical role in portfolio management. I discussed this topic in a previous edition. In this issue, I continue the discussion by presenting different techniques for managing tail risks.

Table of Contents

• Latest Posts

• Hedging with Puts: Do Volatility and Skew Signals …

  • Findings

• Tail Risk Hedging with Corporate Bond ETFs

  • Findings

• Closing Thoughts

• Educational Video

  • Tail Risk Hedging, Convexity and Options

• Volatility Weekly Recap

• Around the Quantosphere

Latest Posts

• Stochastic Volatility Models for Capturing ETF Dynamics and Option Term Structures (11 min)

• Cross-Sectional Momentum: Results from Commodities and Equities (11 min)

• Predictive Information of Options Volume in Equity Markets (11 min)

• The Impact of Market Regimes on Stop Loss Performance (12 min)

• The Limits of Out-of-Sample Testing (12 min)

Hedging with Puts: Do Volatility and Skew Signals Work?

Portfolio hedging remains a complex and challenging task. A straightforward method to hedge an equity portfolio is to buy put options. However, this approach comes at a cost—the option premiums—leading to performance drag. As a result, many research studies are focused on designing effective hedging strategies that offer protection while minimizing costs.

Reference [1] presents the latest research in this area. It examines hedging schemes for equity portfolios using several signals, including MOM (momentum), TREND, HVOL (historical volatility), IVOL (implied volatility), and SKEW. The study also introduces a more refined rehedging strategy for put options:

• If, during the investment period, a put option’s delta falls to −0.9 or lower, the option is sold to lock in profits and avoid losing them in case of a sudden price reversal.

• Put options are bought when implied volatility is below 10%, as they are considered cheap. No position is taken if implied volatility is above 30%, to avoid overpaying for expensive options.

Findings

• The study investigates how option strategies can be integrated into equity portfolios to improve performance under risk constraints. It highlights weaknesses in traditional equity and fixed-income diversification for institutional investors.

• The research tests backward-looking signals from equity markets and forward-looking signals from options markets in covered call and protective put strategies.

• The TREND signal is found to be the most valuable, reducing portfolio risk without reducing returns compared to equity-only portfolios.

• The SKEW signal has a positive impact on GMV allocation but is less effective under EW allocation.

• Adding extra trading rules (TR1, TR2) does not enhance performance and is often negative.

• Backtests of long-put strategies confirm that the TREND signal offers the best balance between downside protection and performance preservation.

• Bootstrapped results diverge from backtests, showing that HVOL and IVOL signals outperform the BASE portfolio in risk-adjusted terms.

• The differences between bootstrap and backtest results suggest that the effectiveness of signals depends on the prevailing market regime.

In short, buying put options using the TREND signal appears to improve portfolio risk-adjusted returns. While SKEW and IVOL add little in backtests, they perform better in bootstrapped results, suggesting that the effectiveness of put protection strategies is regime-dependent.

This study offers a comprehensive evaluation of various hedging rules. There is no conclusive answer yet, implying that designing an efficient hedging strategy is complex and requires ongoing effort. Still, the article is a strong step in the right direction.

Reference

[1] Sylvestre Blanc, Emmanuel Fragnière, Francesc Naya, and Nils S. Tuchschmid, Option Strategies and Market Signals: Do They Add Value to Equity Portfolios?, FinTech 2025, 4(2), 25

Tail Risk Hedging with Corporate Bond ETFs

Reference [2] proposed a tail risk hedging scheme by shorting corporate bonds. Specifically, it constructed three signals—Momentum, Liquidity, and Credit—that can be used in combination to signal entries and exits into short high-yield ETF positions to hedge a bond portfolio.

Findings

• Investment Grade (IG) bonds in the US typically trade at modest spreads over Treasuries, reflecting corporate default risk.

• During market crises, IG spreads widen and liquidity decreases due to rising credit risk and forced selling by asset holders such as mutual funds.

• This non-linear widening of spreads during drawdowns is referred to as downside convexity, which can be captured through short positions in IG ETFs.

• The study develops three signals—Momentum, Liquidity, and Credit—to time entry and exit for short IG positions as a dynamic hedge.

• The dynamic hedge effectively protects high-carry bond funds like PIMIX and avoids drawdowns for funds such as DODIX, even after considering trading and funding costs.

• Each signal captures different aspects of the IG bond market, and their combination provides the strongest results, improving the Sortino ratio by at least 0.7.

• The hedge model performs consistently well across a broad range of tested parameters, showing robustness.

• Shorting IG (LQD) and HY (HYG) ETFs is found to be more cost-effective than shorting individual IG bonds, due to liquidity and low bid-ask spreads.

• IG and HY CDXs, despite larger volumes, lack the downside convexity of ETFs and are less effective for hedging.

Overall, ETF-based hedging delivers both cost efficiency and strong downside protection, making it a practical approach for institutional investors.

An interesting insight from this paper is that it points out how using corporate ETFs benefits from downside convexity, while using credit default swaps, such as IG CDXs, does not.

Reference

[2] Travis Cable, Amir Mani, Wei Qi, Georgios Sotiropoulos and Yiyuan Xiong, On the Efficacy of Shorting Corporate Bonds as a Tail Risk Hedging Solution, arXiv:2504.06289

Closing Thoughts

Both studies highlight the importance of adapting traditional portfolio strategies by incorporating alternative approaches to better manage risk and improve performance. The first paper shows how option-based overlays, particularly when guided by signals such as trend, can enhance equity portfolios by providing downside protection without materially reducing returns. The second paper demonstrates that credit and liquidity risks in investment-grade bonds can be more effectively managed through dynamic hedging with liquid bond ETFs. Together, these findings underscore that integrating derivative-based strategies offers investors practical tools to navigate market volatility, reduce drawdowns, and achieve more resilient portfolio outcomes.

Educational Video

Tail Risk Hedging, Convexity and Options

In this interview, Hari Krishnan explains his long-volatility approach: minimize bleed in quiet regimes and build convex payoffs for stress events. He argues options now interact tightly with the underlying (“tail wagging the dog”) as retail flows, passive/vol-control frameworks, and market-maker hedging amplify moves; ETF liquidity can look fine until a shock forces fast reversals.

He focuses on buying protection when complacency is high, transitioning from vega-to-gamma-oriented hedges as conditions worsen, and exploiting VIX term-structure dynamics (e.g., contango drift supporting certain long-put structures). Risk, in his view, is not volatility alone but a mix of positioning, leverage, and credit—areas central banks can influence at the median via balance-sheet changes, but not fully control. He prefers right-tail hedges when carry helps (rates vs dividends), avoids earnings-lottery trades, and sizes positions by payout-per-premium rather than Sharpe optimization. He blends discretionary judgment with simple, implementable structures, draws on complex-systems thinking (delays can destabilize), and uses a “regret minimization” mindset to stay disciplined and independent.

Volatility Weekly Recap

The figure below shows the term structures for the VIX futures (in colour) and the spot VIX (in grey).

The S&P 500 fell at the start of the holiday-shortened trading week, rallied to a new all-time high midweek, and then pulled back on Friday. For the week, the S&P 500 gained 0.33%, and the Nasdaq rose 1.14%. Oil prices declined, while gold surged to new all-time highs. Bitcoin briefly dipped below the prior week’s low before rebounding.

On the volatility front, conditions remained largely unchanged from last week, with both spot and VIX futures in contango and the roll yield staying elevated.

Around the Quantosphere

• Hedge Fund Coach: "Everything is on the table, including personal life" (efinancialcareers)

• Breaking down the trading industry: Discover your role (optiver)

• Hedge Fund AQR Loses $4.7 Billion Dutch Pension Fund Mandate (bloomberg)

• What's a Quant Developer in a Bank or Hedge Fund? (efinancialcareers)

• The 600 Humble Traders Who Shared $20bn Last Year (efinancialcareers-canada)

• Traders Brush Off Inflation Risk as They Bet on Smooth Rate Path (bloomberg)

• Jane Street's Asia Expansion: A Strategic Bet on Quant‑Driven Liquidity in Emerging Markets (ainvest)

• $7 Billion Profit! Wall Street Trader Who Milked Crores from India Turned Trump Tariffs into a Fortune (economictimes)

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