By |Published On: August 24th, 2015|Categories: Uncategorized|

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 un-managed, 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.

About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia 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 firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.