We Study Billionaires - The Investor’s Podcast Network
Episode: TIP702: Hedging Against Market Crashes with Chris Citiel
Release Date: February 28, 2025

Introduction

In episode TIP702 of We Study Billionaires, hosts Clay Fink and Chris Citiel delve deep into the intricacies of tail risk hedging—a strategy designed to protect investors against extreme market downturns. Chris Citiel, co-investment officer of Ambris Group, shares his expertise on implementing carry-neutral tail risk hedging strategies, their benefits, and the evolving nature of financial markets that necessitates such approaches.

Defining Tail Risk Hedging

Timestamp: 02:37 – 04:11

Chris begins by demystifying tail risk hedging, explaining it as a strategy that guards against significant market downturns. "A tail risk hedge is something that ends up being uncorrelated to the market, but then becomes correlated when markets are going down," Chris explains (04:11). This approach acts similarly to portfolio insurance, allowing investors to mitigate large drawdowns and achieve a smoother return profile over time.

Implementation Strategies

Timestamp: 04:40 – 06:25

Discussing the tools of tail risk hedging, Chris emphasizes the use of derivatives, particularly options. "They're focusing on things that could pay out one to a hundred times what you laid down," he notes (04:40). Unlike some hedge funds that may employ strategies like shorting futures or buying gold with linear payoff profiles, Chris highlights the advantage of options for their asymmetrical payoff potential. This asymmetry allows for significant gains during periods of high volatility without consistently bleeding capital during stable markets.

Understanding VIX and Market Volatility

Timestamp: 06:25 – 09:08

A key component of tail risk hedging is understanding the VIX, often referred to as the "fear index." Chris elaborates, "It's a calculation that runs... as the implied volatility is increasing... VIX starts going higher" (06:25). He describes the VIX as "volatility on steroids," explaining that during market panics, the VIX can spike dramatically, offering lucrative opportunities for tail risk strategies. March 2020 serves as a prime example where the VIX surged, underscoring the effectiveness of tail risk hedging during such crises.

Historical Market Blowups and Strategy Performance

Timestamp: 09:08 – 15:20

Highlighting historical instances, Chris lists numerous events where the VIX spiked beyond 40, such as the Global Financial Crisis (VIX peaked at 96 in August 2008) and the COVID-induced crash in March 2020 (VIX reached 85). "These events happen much more frequently than people think," he asserts (15:20). During these periods, tail risk strategies have historically performed exceptionally well, often yielding triple-digit returns, providing essential protection and capital preservation for investors.

Market Reflexivity and Self-Reinforcing Dynamics

Timestamp: 20:07 – 24:45

Chris introduces the concept of market reflexivity, explaining how modern market structures amplify volatility. "The new market microstructure has led to this amplified form of reflexivity," he states (20:52). Factors such as the growth of ETFs, passive investing, and regulatory changes post-Dodd-Frank have made markets more susceptible to rapid and violent drawdowns. This reflexivity means that during downturns, selling pressure can intensify quickly, making tail risk hedges even more crucial.

Profit Taking During Volatile Periods

Timestamp: 25:03 – 27:33

Addressing the challenge of taking profits during market crashes, Chris emphasizes a balanced approach. "You can never be fully systematic when you're trading a long volatility style," he notes (25:37). Successful strategies often blend quantitative models with discretionary decision-making, allowing managers to monetize appropriately when option prices surge, ensuring they capture gains without prematurely exiting positions.

Short Volatility Trend and Market Impact

Timestamp: 27:33 – 30:25

Chris discusses the popularity of shorting volatility, a strategy that has seen a sixfold increase in Assets Under Management (AUM) in recent years. "Shorting volatility is a bet against the abnormal," he explains (27:50). While selling options can be profitable when markets remain stable, it carries significant risks during upheavals. Overcrowded short volatility positions can lead to abrupt market corrections when tail events occur, causing substantial losses for those unprepared.

Portfolio Allocation for Investors

Timestamp: 30:27 – 33:45

When it comes to integrating tail risk hedging into portfolios, Chris outlines two primary investor types: opportunistic traders and defensive high-net-worth individuals. "Defensive people are just looking for something to offset the losses in their portfolio," he says (30:35). Allocating 5-10% of a portfolio to tail risk strategies can provide crucial protection during market crashes, acting similarly to holding cash but with the added benefit of appreciating during downturns.

Minimizing Drawdowns in Normal Markets

Timestamp: 38:10 – 43:38

Maintaining capital during stable periods is a significant challenge for tail risk strategies. Chris emphasizes the importance of minimizing "bleed" by employing a blend of quantitative and discretionary approaches. "In normal markets, you just flatten out, but when things become dislocated, the tails just pick up," he explains (38:38). By focusing on short-term edges within U.S. equities and derivatives, Ambris Group ensures consistent performance, offsetting potential losses and preserving capital for when tail events occur.

Future Volatility and Market Fragility

Timestamp: 43:38 – 45:43

Chris anticipates continued sporadic bursts of volatility due to evolving market microstructures and increased options activity. "Every few years you get these bursts of volatility," he predicts (43:38). The proliferation of options trading exacerbates the impact of dealer gamma hedging, making markets more reactive and volatile. He remains confident that their tail risk strategies are well-positioned to capitalize on these future volatility spikes.

Regulatory Risks and Tail Risk Strategies

Timestamp: 47:50 – 49:30

Addressing concerns about regulatory intervention, Chris asserts the resilience of tail risk strategies. "It's very unlikely that regulators will ban these strategies," he states (47:50). By focusing on listed options and avoiding exotic derivatives, Ambris Group mitigates counterparty risks and maintains compliance, ensuring their strategies remain viable even amidst potential regulatory changes.

Inspirations and Influential Traders

Timestamp: 49:30 – 51:48

Chris shares his admiration for legendary traders like Michael Platt of BlueCrest, Vinnie Viola of Virtu, and Ed Thorpe of LTCM. He highlights the importance of discipline, process-driven strategies, and understanding market dynamics. His favorite book, The Misbehavior of Markets by Benoit Mandelbrot, has significantly influenced his approach by elucidating the instability and non-Gaussian nature of financial markets.

Conclusion and Contact Information

Timestamp: 52:14 – End

Wrapping up the episode, Chris encourages listeners to explore tail risk hedging further. Interested individuals can visit AmbrusGroup.com or connect with him on Twitter (@Ksidi) for more insights into volatility trading and tail risk strategies. He emphasizes the importance of sticking with insurance strategies to safeguard portfolios against unforeseen market crashes.

Notable Quotes:

• "A tail risk hedge is something that ends up being uncorrelated to the market, but then becomes correlated when markets are going down." — Chris Citiel [04:11]

• "Selling volatility is a bet against the abnormal." — Chris Citiel [27:50]

• "In normal markets, you just flatten out, but when things become dislocated, the tails just pick up." — Chris Citiel [38:38]

• "Every few years you get these bursts of volatility." — Chris Citiel [43:38]

• "It's very unlikely that regulators will ban these strategies." — Chris Citiel [47:50]

About the Hosts:

• Clay Fink: Co-host of We Study Billionaires, bringing his expertise in financial markets and investment strategies to listeners worldwide.

• Chris Citiel: Co-investment officer at Ambris Group, specializing in tail risk hedging and volatility trading strategies to protect and enhance investor portfolios.

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