Six Expert Tips for Managing Tail Risk | tradeTALK Blog Series
Apr 23, 2021
Risk is an integral component of trading and investing, because without risk, there's usually no reward. Ultimately, that means all investors and traders at their core are risk managers.
Investors and traders seeking to optimize their risk management skills might therefore want to review a recent Trade Talk on the tastytrade financial network featuring Tom Sosnoff—co-founder and co-CEO of tastytrade.
In this installment of Trade Talk, Tom provides personal insight into one of the more complex elements of risk management—managing positions that have suffered from an "irrational move."
At tastytrade, strategic risk management of such situations is generally referred to as "defending tested positions." In the video, Tom walks viewers through his personal defensive playbook when a position gets severely tested due to an "irrational move."
Readers should note that irrational moves are essentially representations of “tail risk”—the latter being dramatic, low-probability events that typically result in gap moves.
Technically, tail risk is defined as a move of more than three standard deviations in the price of an underlying asset. In layman's terms, that’s like three different rocking chairs simultaneously pinning down a single cat's tail.
On his Trade Talk, Tom walks viewers through a list of potential responses that can be considered when dealing with these situations.
But before jumping into those tactics, it's important to highlight that when defending against tested positions, investors and traders basically have four options to choose from:
Close the tested position
Reduce exposure in the tested position
Let the tested position work (i.e. do nothing)
Roll the tested position into a longer-dated expiration
Depending on one’s own unique risk profile and market outlook, any of the above four choices could be appropriate in a given situation.
Importantly, this Trade Talk specifically focuses on the second bullet point above—reducing exposure in a tested position.
With that in mind, let's jump into Tom’s insights on defensive tactics for irrational moves.
Nobody likes to lose money, and least of all passionate investors and traders. But experienced market participants also know the reality of being in the markets—not every position is going to win.
However, irrational moves—like the one observed in GameStop (GME) in early 2021—are unique.
Given the unpredictability of the situation (and the gravity), it’s probably not optimal to increase position size. That’s like doubling down on a bad hand at the blackjack table.
Just like it’s prudent to avoid doubling down on a bad hand, it may also be prudent to reduce position size in a severely tested position.
It’s well established that “the market can stay inefficient longer than a trader/investor can stay solvent.”
If fundamentals have been tossed out the window, the original premise behind the position is also no longer likely relevant. Taking that under consideration, it may be prudent to reduce exposure in the position by at least 25-33%, if not taking it off altogether.
If a trader decides to reduce size in a severely tested position, he/she might also choose to hedge the position.
The purpose of a hedge is to provide additional protection in case the position continues to move south. If the existing position is subject to considerably upside risk, an investor/trader might consider purchasing stock as a hedge.
In this situation, using a static delta with stock or futures may provide a more robust form of protection than additional options—depending on one’s risk profile and market outlook.
For traders and investors that choose to reduce the size of the position—as opposed to closing it outright—it may be prudent to reassess the expected outcome.
What’s the new best-case scenario for the position? What’s the new worst-case scenario?
Once a trader has accepted the new expected outcomes, he/she can move forward and manage the position in a disciplined, mechanical fashion—as opposed to relying on knee-jerk, emotional decision-making.
On occasion, losing positions occur—that’s a part of the game.
Normally, investors and traders want to maximize occurrences (i.e. trade more), to give themselves the best chance of achieving targeted probabilities of profit (POP).
However, when irrational situations arise in the marketplace, it may be prudent to avoid deploying similar/correlated ideas. Because when irrational moves materialize, the worst case outcome isn’t losing on a single position—it’s losing on multiple positions.
Traders therefore should avoid adding positions of a similar nature when dealing with such adversity. And maybe even consider closing positions in the portfolio that could potentially suffer from collateral damage.
Adverse trading events related to irrational moves aren’t easy on the psyche. But you aren’t alone. Virtually every investor and trader in the market has suffered from an irrational move.
Like any tough situation in life, the best one can do is learn from it. Moving forward, that may involve reducing average position size, to minimize the impact of future irrational moves.
One also has to keep in mind that irrational moves aren’t commonplace—which is why they fall under the category of tail risk.
Markets and pricing models are mostly efficient, which is why active investors and traders are drawn to the financial markets in the first place.
To get the full skinny on defending severely tested positions, readers are encouraged to review Tom’s complete Trade Talk on this topic.
For more trading and investing insights, and to follow everything moving the markets, readers can also tune into tastytrade for programming 7 days a week!
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