Selling Insurance: An Option for Diversification

October 03, 2023 | Evan Frazier, CFA, CAIA, Senior Research Analyst

This chart description is for illustrative purposes only and its accuracy cannot be guaranteed. Please see full disclosures at end of PDF document in the web post. General description: Combination line and column chart showing volatility spread and calendar year returns for the CBOE S&P 500 PutWrite Index and S&P 500. Chart subtitle: Over the last few decades, options-based strategies have generated compelling patterns of performance thanks to differences between implied and realized market volatility. Chart source: Source: Bloomberg and eVestment as of September 30, 2023. Volatility spread is calculated as the difference between implied volatility, as measured by the VIX Index, and realized volatility of the S&P 500 Index over the subsequent 1-month period (21 trading days). Realized volatility is calculated as the standard deviation of daily logarithmic returns multiplied by an annualization factor. Chart visual description: Left Y-axis is labeled Spread and ranges from -80% to +40%. X-axis labels span years from 1990 to 2023. Right Y-axis is labeled Cal. Year Return from -40% to +40%. Each data set has its own X-axis, so orange line chart corresponding to Volatility Spread floats above column chart for calendar year returns. Average Volatility Spread line is dotted in dark orange at 4.5%. CBOE S&P 500 PutWrite Index is plotted in green columns and S&P 500 Index is plotted in blue columns. Chart data description: Data for index returns is annual; data for volatility is daily. Please contact us for the full dataset. End chart description. See disclosures at end of document.

The Aflac Duck, the LiMu Emu, and the GEICO Gecko may be fictional insurance salespeople (or sales-animals, perhaps), however, the market participants involved in the selling of financial insurance are all too real. Put options are a popular form of such insurance, as these instruments afford the option holder the right to sell an underlying security at a given level, effectively insulating the holder against significant drops in the price of the underlying security. That said, much like bundling your home and auto with Jake from State Farm, this insurance comes at a cost based on implied volatility. For those who choose to purchase options contacts on the broad-based S&P 500 Index as a means of insuring portfolios against losses, this implied volatility is measured by the VIX Index, which uses at-the-money S&P 500 Index options to assess expectations of near-term market fluctuations. Over the long term, these expected volatility levels tend to be higher than what is actually exhibited. Specifically, since the start of 1990, implied volatility of the S&P 500 Index was greater than what was subsequently realized in roughly 87% of daily observations, and the difference between the two was roughly 4.5% on average over the same time period. This phenomenon leads to the systematic over-pricing of put option contacts and is highlighted in the top half of this week’s chart.

The data points noted above demonstrate the fact that selling insurance contracts on the U.S. equity market has generally been a profitable endeavor over the last several decades. To that point, the CBOE S&P 500 PutWrite Index, which is comprised of short positions in at-the-money put options on the S&P 500 Index and short-term Treasury bills which serve to collateralize the option positions, is an effective tool for measuring exactly how beneficial this activity can be for investors. On a trailing 10-year basis as of September 30, the PutWrite index notched an annualized return of 6.7%. While this is significantly lower than the 13.1% figure for the S&P 500 over the same period, the PutWrite benchmark has notably delivered that performance with a lower annualized standard deviation — 9.7% vs. 15.0% for the S&P 500. Performance of the PutWrite benchmark during down markets has been particularly compelling, with the index outperforming the S&P 500 in six of the last seven calendar years during which the S&P 500 was negative. This performance pattern can be observed in the bottom half of this week’s chart. It is important to note that active managers within the space can provide additional value over the PutWrite index by selling the most attractive options, diversifying the portfolio of options across different strike prices and tenors, and optimizing the pool of cash with which the options are collateralized.

Readers should be aware of the fact that options selling is not without risk. Performance typically lags during strong, upward-trending markets, and a relatively high equity beta means that these types of strategies will be more correlated to stock market movements than other diversifying alternatives. That said, options-based strategies could present attractive opportunities for many investors due to the systematic processes with which they are implemented, the lower fees and better liquidity terms associated with them relative to other alternatives, and the likelihood that the volatility risk premium will persist into the future. Marquette will continue to monitor the persistence of this premium, conduct due diligence on investment managers in the options space, and provide education and recommendations to clients accordingly.

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Evan Frazier, CFA, CAIA
Senior Research Analyst

Get to Know Evan

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

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