Everyone's Just Gonna Wait Until The Next Crash To Buy Crash Insurance

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Will stocks go down? Sure, maybe, whatever. I mean, they have so far today, I don't know. It's a thing that might happen and you might want to bet on it, one way or another. If you want to bet against it - if you think stocks won't go down, or won't go down by that much - then broadly speaking you can do one of two things, which are:

  • Buy stocks, and get paid for taking the risk of stocks going down by getting the chance that they'll go up, or
  • Sell puts, and get paid for taking the risk of stocks going down by getting money.

That's basically the world: you take a risk, and you get paid for taking that risk either with a fixed payment or an uncertain upside.1 You could imagine some sort of long-run expectation in which those strategies would be equivalent and I guess you wouldn't be entirely wrong. Here is a graph:

That's from a Goldman Sachs Options Research note out yesterday, and compares (1) buying and holding the S&P 500 (light blue line) with (2) selling one-month at-the-money puts on the S&P 500 stocks every month (black line), as well as the somewhat less relevant (3) just buying bonds. GS is recommending that you sell puts so the rest of the report is full of ideas to make that black line go higher but I hope you're not here for investing advice so I'll leave that to them.

They come down on the sell-puts side because it makes you almost as much money as buying stock, with less risk:

Passive put selling generated annual returns of 7.1% over the past 10 years with monthly volatility one-third less the S&P 500. We estimate that selling 1-month at-the-money (ATM) puts on all optionable stocks in the S&P 500 collected an average of 40% in premium each year and generated a compound annual return of 7.1% over the past 10 years, roughly in-line with the annual returns of the S&P 500 total return of 7.3%. The volatility of this passive put selling strategy was 12% vs. the 18% volatility of the stock only strategy. Similarly, put selling had a higher Sharpe ratio than owning stocks (0.65 vs. 0.49).

The volatility part is sort of intuitive: Getting paid a fixed amount of cash to take equity risk is usually a less volatile strategy than getting paid an uncertain amount of upside to take the same equity risk, because fixed amounts are less volatile than uncertain amounts. (Right?)

The returns part is, basically, that over the last ten years the fixed-cash approach paid just a smidge less than the uncertain-upside approach. One intuitive way to read that is that the people buying puts from you were, on average, pretty accurately predicting how much those puts were "worth" in equity upside, so the ultimate payoff of the two approaches to getting paid for taking equity risk was mostly similar.

But only as a 10-year average: the put buyers were effectively underpaying from '04 to '09, overpaying since '09, and are just getting back to their previous pattern of underpaying.2 Presumably Goldman's advice - "everyone start selling puts now" - will speed that along.

Which I guess will be helpful for the people buying the puts? That may or may not be interesting background to this Reuters article about how investors have lost interest in "black swan" hedge funds that insure them against market-crash tail risk:3

Capula, one of the top 10 largest European hedge funds, has lost close to half the assets - about $1.1 billion - in its Tail Risk Fund since mid-2012, two investors in the fund said.

The fund, which now runs $1.4 billion, fell more than 14 percent last year as investors' belief grew that the ECB would do all it could to calm the euro zone crisis when borrowing costs were soaring for Spain and Italy.

Other tail risk funds also slumped in 2012, with U.S.-based Pine River Capital's down 36 percent and its assets falling to $200 million from $300 million, a separate investor in its fund said. Both firms declined to comment.

This article is so comically on-the-nose as an indicator of an imminent and huge market crash - it's an article about how no one's worried about a market crash; when the shoeshine boys have lost interest in tail-risk hedging, run - that I think it wraps around the other way, so I'm going to take it as a signal that everything will be fine. You do what you want, though.

Different funds are reacting in different ways; there are the stoic true believers:

Pine River's fund, which charges no performance fee so that its managers have no incentive to stray from the mandate that it acts as insurance, is designed to lose 2.5 percent per month in flat markets.

Endorsed! Then there are the compromisers:

This year [Capula] "re-positioned" its Tail Risk Fund so it is less correlated to short-term market moves. It is up 0.56 percent so far in 2013, a person familiar with the fund said.

I vaguely recall another tail-risk hedge that was re-positioned to make money in rising markets.

And then, finally, there are the quitters:

Unigestion set up a tail risk product after the financial crisis began but shut it in 2010 as markets rallied. Last year the firm considered re-launching but decided not to proceed.

Right, obviously when you start selling tail-risk insurance after a crash, and stop selling it as markets rally, your only real choice is to wait until after the next crash before re-launching. Anything else is practically cheating.

Investors turn their backs on "black swan" hedge funds [Reuters]

1.Two corollaries:

  • Instead of selling puts you could buy stock and sell calls; by put-call parity those are the same thing. "Selling puts" sounds sort of weird; "buying stock and selling calls" is called a "buy-write strategy" and it's a thing that people do. The Goldman researchers say "We estimate that short puts account for 25% of all mutual fund option positions; another 60% of options positions are buy-writes which have a similar risk/return profile."
  • Here you can read a man making the baffling claim that "There are only two ways to finance a company: with equity and with debt. ... There is no in-between." It's baffling because he's writing about Barclays' sale of contingent capital securities, which are in between debt and equity. (And are just one of many such things; so much of corporate finance is about cooking up things that are between debt and equity.) But "getting paid for risk with upside or a fixed return" is a way to think of cocos: basically, you can take the risk of Barclays' equity cratering either (1) in the form of buying the stock and getting the upside of Barclays' equity or (2) in the form of buying the cocos and getting 7% a year. Opacity and gamesmanship around capital ratios makes that tradeoff not as easily analyzable as it should be but whatever.

2.In that loose, versus-stock-upside sense. Obviously you could look at implied versus realized vols or whatever if you wanted to decide if put buyers "overpay" or "underpay" in a Black-Scholes-y sense.

3.Obviously the people running tail-risk money recommend that you buy puts:

"Across asset classes volatility is exceptionally low. Volatility is the most mispriced thing in financial markets (at the moment)," Boaz Weinstein, who heads hedge fund Saba Capital, told a conference in New York last month.

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