The Best Way to Hedge Election Risk
- Dominick Paoloni
- November 3, 2024
- 11:07 am
The Best Way to Hedge Election Risk
Nassim Taleb once said, “If you are not hedging, you shouldn’t be investing.”
With the upcoming election, what is an inexpensive hedge to consider? Given a steep reverse skew, a classic 1 x 1.5 put ratio spread is Taleb’s go-to trade.
In 2020, during the March COVID Crash, Taleb placed a 1 x 1.5 put ratio spread with a 1 delta on the long side and a 0.35 delta on the short side, 90 days to expiry. The market dropped 35% in 30 days, and Taleb made 3,612%.
If we consider the drawdown during the 2000 election (Bush vs. Gore), which took over 30 days to resolve and resulted in a drawdown close to 10%, a 57-day trade with a 20 delta on the long side and an 8 delta on the short side (1 x 1.5) could deliver a return of 6 times your capital when the trade goes delta-neutral. The Greeks initially deliver positive theta, positive gamma, and negative delta.
The Trade P/L look like this:
If you get a vol crush of just 3% (like vol does around earnings) you would receive an 8X on your capital
When the trade goes delta neutral
The market would have to drop 16.4% for this trade to go delta neutral. When the trade does goes delta neutral you could:
- Remove the trade locking in a profit
- Restrike the trade lower, monetizing most of your profit
- Butterfly the trade buy buying a further OTM put
In Conclusion:
If an investor wanted to hedge off their downside risk using 10, 20-Delta Puts, the cost of that trade would run approximately $50,000. If they used a ratio as shown, the cost of the trade would run only $19,000.
What this shows is that when the reverse skew is very steep, you can get a very favorable cost-to-return profile creating an inexpensive hedge opportunity.
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