Avoid Buying Put Insurance When You are Most Afraid

/Avoid Buying Put Insurance When You are Most Afraid

Avoid Buying Put Insurance When You are Most Afraid

By | 2017-08-18T17:09:54+00:00 August 24th, 2015|Uncategorized|Comments Off on Avoid Buying Put Insurance When You are Most Afraid

A timely piece on S&P 500 put option prices. The authors find that S&P 500 put options get too expensive during wild times because of 2 effects:

  1. Demand for insurance sky rockets (investor utility demands safety)
  2. Supply for insurance becomes restricted (credit constraints cripple market makers)

The lesson seems to be straight forward: buy insurance when you don’t “feel” like you need it; avoid buying insurance when you “feel” like you need it (ie. insurance prices can become more expensive–and move away from theoretical prices–in market downturns).

The Supply and Demand of S&P 500 Put Options

We document that the skew of S&P500 index puts is non-decreasing in the disaster index and risk-neutral variance, contrary to the implications of no-arbitrage models. Our model resolves the puzzle by recognizing that, as the disaster risk increases, customers demand more puts as insurance while market makers become more credit constrained in writing puts. The skew steepens because the credit constraint is more sensitive to out-of-the-money puts. Consistent with the data, the model also predicts that the skew is increasing in the broker-dealers’ liability-to-asset ratio; and the net buy of puts is decreasing in the disaster index, variance, put price, and liability-to-asset ratio.

Here are the theoretical IV Skew and Disaster Index results:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

And here are the empirical results:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.


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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.