Time for a little myth busting.
Recently, the Motley Fool posted an article that argued the following: when market volatility is low, protective put options are cheap.
From the article:
Smart investors know that the time to buy most investments is when most investors aren’t paying attention to them. The same is true of options. Typically, put options are cheapest during big bull markets, especially when major market benchmarks are climbing strongly. That’s because options traders don’t value protection highly when the market has upward momentum…Therefore, if you think about protective puts when it seems like you don’t really need them, then you’ll put yourself in the best position to pick them up cheaply.
In the current market environment, investors are understandably worried about tail risk. Overall asset valuations are high, uncertainly is elevated, and markets have been generally stable for a long time.
Investors worried about the prospect of a big market drawdown often look for portfolio insurance for protection. The best sort of insurance is cheap insurance. We’ve written on a few ways to buy insurance on the cheap. For example, we wrote here about how US Treasury Bonds, Hedge Fund Factors, and Managed Futures tend to go up when markets go down, thus providing insurance-like protection, in expectation. The benefit of these insurance programs is they tend to have positive carry, however — and this is a big “however†— these “crisis alpha†concepts aren’t guaranteed to provide downside protection when the world blows up in the future. The only pure equity market insurance asset is buying puts on equity markets, which will mechanically protect the downside if equity markets explode. But the downside of buying puts is they come at a cost, in form of an option premium.
Understanding Protective Puts
Long put options also go up in value when the underlying goes down, and so seem like a reasonable insurance asset candidate, although you don’t get paid to hold them as with the instruments above; instead they come at a cost.
So how much are we paying for this insurance?
If we are focused on cost, perhaps put options are a better bargain at some times when compared with other times? We wrote here about a paper that argued that as disaster risk increases, demand for put insurance skyrockets, but market makers become constrained from writing puts, making them expensive.
What about when markets are calm? Perhaps during such times put options are cheap?
So it would seem that put insurance is indeed cheap in calmer markets. It’s a great story, but is it borne out by the evidence?
In “Still Not Cheap: Portfolio Protection in Calm Markets,†by Roni Israelov and Lars Nielsen, the authors argue this is an overly simplistic view. What matters for assessing whether an option is expensive or cheap is not whether implied volatility is low relative to its history. The only thing that matters is the option’s price relative to its fundamentals — the difference between the options implied volatility and its realized volatility.
