Avoid Buying Put Insurance When You are Most Afraid

Wesley Gray |

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Here's 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 largely due to two specific effects:

  1. Demand for insurance skyrockets (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 (i.e. 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 whilemarket 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:

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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:

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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.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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