Buying Insurance on the Titanic: Tail Risk Hedging
Buying Insurance on the Titanic: Tail Risk Hedging
Diversification fails when you need it most (Correlation goes to 1). Why throwing money away on Put Options is the most rational act for wealth preservation.
Executive Summary
- The Correlation Trap: In a normal market, Stocks and Bonds are uncorrelated. In a crash (e.g., March 2020), everything falls together. Liquidity dries up, and diversification stops working.
- The Put Option Shield: A “Deep Out-of-the-Money Put Option” is a contract that pays out only if the market crashes massively (e.g., -20% or more). It is cheap to buy when skies are clear.
- The 100x Payoff: When the Black Swan hits, these cheap options explode in value (often 50x to 100x). This massive cash infusion acts as a “Cash Cannon,” allowing you to buy stocks at the absolute bottom when everyone else is selling.
The Cost of Bleeding
Psychological Torture: Tail Risk Hedging means you will lose small amounts of money 99% of the time. You are buying fire insurance on a house that hasn’t burned down in 10 years. Most investors quit the strategy right before the fire starts.
Mechanic: The Convex Payoff Curve
Convexity
Explosive Gain
OTM Puts
The Instrument
Liquidity
Cash in Panic
Premium
Annual Drag
Simulation: The Covid Crash (March 2020 Scenario)
Portfolio Behavior during -33% Crash
| Feature | Stop Loss Order | Tail Risk Hedge (Puts) |
|---|---|---|
| Mechanism | Sell after price drops | Profit increases as price drops |
| Crash Performance | Fails (Gap Down / No Liquidity) | Guaranteed Contractual Payout |
| Cost | Free (theoretically) | 1-2% of Portfolio / Year |
“Tail hedging allows you to be an aggressive investor. You can hold more risky assets because you know the ‘Doomsday Insurance’ is in your pocket. It transforms you from a victim of volatility into a beneficiary of it.”
Essential Resources
INTERNAL
BMT Playbooks