Volatility in the equity markets has subsided, courtesy of a strong bull market and fading memories of the 2008 financial crisis.  Risks remain, however, ranging from the turmoil in northern Africa to sovereign debt instability in Europe.  Investors can take advantage of the complacency in the equity markets by purchasing inexpensive insurance against adverse events.
The most direct way to limit risk is through tail insurance.  The simplest form of tail insurance is to purchase a derivative that limits portfolio losses under extreme adverse conditions. 

In a previous article, I explored using put options on long-dated government bonds as a way to protect against a spike in interest rates.  In this article, I explore tail insurance against a major decline in the S&P 500. 

The most basic form of tail insurance is out-of-the-money (OTM) put options on an index ETF, such as the SPY.  The goal of holding these put options is to limit the impact of extremely low-probability but tremendously severe events – so-called “black swans.” 

The challenge is that this type of protection against extreme market movements is usually expensive, a consideration I’ll analyze in more detail later.

PIMCO, in particular, has popularized the concept of tail insurance.  PIMCO launched its Global Multi Asset Fund (PGAIX) at the end of October 2008.  One of the three explicit strategies this fund employs is to hedge against extreme outcomes with various forms of tail insurance.  Since its launch, the fund has not out-performed a generic 60/40 portfolio (its stated benchmark), but we have not experienced sufficiently extreme market movements since the fund’s launch to fairly evaluate the effectiveness of PIMCO’s strategy. 

PIMCO’s approach emphasizes the importance of cheaply purchasing tail risk.  In addition, PIMCO makes a point to analyze how a range of extreme scenarios can be managed and selects tail-risk instruments to fit specific worst-case scenarios.  Doing so requires a probabilistic approach, which must be tempered by our limited ability to calculate the probabilities and severity of rare extreme events. 

To evaluate the various forms of tail insurance available for protection against a major decline in the S&P500 (or any other market, for that matter), we must understand how options affect portfolio outcomes.  In this article, I explore a series of ways to implement tail insurance against a decline in the S&P500, and I also consider the cost-effectiveness of each solution. 

Understanding protective options

We will start with the simplest case.  An investor who owns the S&P 500 via the ETF SPY can set a floor on his potential losses buying a put option on the ETF.  The chart below shows a simulation of the future one-year outcomes for SPY, with and without the purchase of a one-year put option on SPY.  This example estimates using current ask price for the put option the actual price at which the put can be purchased  and the current implied volatility.

The chart below shows the estimated percentile probability of outcomes after one year.  The 65th percentile outcome is for SPY is $155 after one year, for example.  This means that there is a 65% probability that the price of SPY in 12 months will be at or below $155.  Conversely, there is a 35% probability that SPY will be above $155 in 12 months. 

One share of SPY vs. one share of SPY with a $110 put option

Value of Position in 1 yr