Tail Risk Hedging Using LEAPS and Structured Options

Abstract

Tail risk events are extreme events, and low-probability events that particularly have high impact on portfolio stability and long-term investment performance. The paper describes the way these extreme downside risks can be hedged in the case of Long-Term Equity Anticipation Securities (LEAPS) and structured options. Unlike traditional hedging strategies, which are characteristic of short-term option usages with periodic rollover charges and may not provide adequate protection to investors during long-term fluctuations, LEAPS provide long-term investment maturities that are more aligned with long-term investment horizons. Structured options, on the other hand, also provide customized and flexible solutions, such as collars, barrier options and spreads, that enable investors to balance a cost and protection against severe market dislocations. This paper highlights the strengths and weaknesses of each of these tools through comparative analysis and how they can be used in diversified risk management models.
Additionally, it addresses some of the key issues that can be encountered in implementing such tools, including the unavailability of liquidity, complicated pricing, and regulatory concerns of which portfolio managers must be aware. These findings suggest that the integration of LEAPS and structured options into portfolio strategies can help find resilience, reduce drawdowns and provide investors with a systematic approach to dealing with uncertainty in more volatile markets. Lastly, the study identifies the importance of proactive hedging in long-term capital and financial stability.