“Tail risk means the risk of a sudden and steep drop in market valuations, a down move of 20% or more,” according to a CBOE VIX Tail Hedge Index white paper. “What makes VIX call options such a good remedy for tail risk is that these options may generate astronomically high returns in turbulent periods.”
Basically, the strategy hedges against unpredictable, random and unexpected events. The term black swan was coined in a 2007 book by Nassim Nicholas Taleb published right before the financial crisis hit.
In a recent study, State Street Global Advisors, along with the Economist Intelligence Unit, found that 71% of institutional investors think it is “highly likely” or “likely” that a significant tail risk event will take place over the next year. Respondents cited the crisis in the Eurozone, a potential global or European recession and a slowdown in China among their top concerns. [VIX ETFs Show Market Complacency as Stocks Flirt with Record Highs]
Additionally, 64% of the institutional investors pointed to liquidity of the underlying instruments as the major challenge in allocation to a tail risk protection strategy.
For more information on market volatility, visit our volatility category.
Max Chen contributed to this article.