Chapter 4Hedging the Wings

Here, we explore practical ways to hedge against ruin, at relatively low cost. We focus on the short 1×2 ratio spread on equity indices and bonds and the short VIX futures, long VIX calls strategy. Both are designed to provide powerful extreme event protection while collecting premium or benefitting from roll down. Naturally, there are subtleties to every trade that can only be learned by experience. However, this chapter should provide a rough road map to hedging equity and interest rate risk. The structures in this chapter should be broadly applicable to any market where the implied volatility skew moves in a predictable way during a crisis.


Hedging the “wings” conjures up the bizarre image of the market return distribution as some sort of bird, a phoenix rising from the ashes, perhaps. Nonetheless, the phrase is widely used. The wings refer to the extremes of the distribution. If the 1×2 is so dangerous, why not turn it on its head? Selling the 1×2 is an inexpensive way to isolate the put skew in advance of a crisis. This is not to say that we want to short a ratio spread with the same strikes as the Batman trade in Chapter 3. For extreme event hedging, we typically target lower deltas than the Batman trade does, as we want to profit from a significant repricing of extreme event risk. The hedge is not really concerned with moderate moves in the spot. Figure 4.1 pushes our deltas further out along the put skew.

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