Tail hedge
Why would a trader pay for protection that usually loses money, and when does that protection actually matter?
In plain words
A tail hedge is a position bought specifically to pay off during rare, extreme market moves rather than in normal trading. It is usually expected to lose a small amount most of the time, in exchange for a large payoff when a sudden, sharp fall happens.
Why it matters
Most risk comes from the rare moves that ordinary hedging ignores. A tail hedge accepts a steady small cost so that a portfolio is not destroyed when the market moves violently in a single hour or day, which can happen even when the overall week looks calm.
In a real week: ETH, week of 30 November 2020
In the week of 30 November 2020, ETH closed 4.38% higher at 601.54, yet it swung between 560.00 and 635.70, a 13.52% range, and recorded a worst day of -7.89% and a largest one-hour move of -6.34% on Tuesday 1 December at 12:00 UTC. A tail hedge held only through the week would likely have cost money overall, but the week's realised volatility reached 93.0% annualised.
A common mistake
Judging a tail hedge by whether it made money in a given week. Most weeks it loses a small amount by design; its purpose is to pay off only in the rare weeks when markets move violently.