It may come as no big surprise that you wouldn’t have much luck trying to purchase flood insurance for your home on a barrier island in the middle of a catastrophic hurricane. However, let’s say that by “lottery luck” you were somehow successful in your endeavor to purchase an insurance policy the price would no doubt be at quite the premium. By comparison, investors have the luxury of liquid and accessible markets daily regardless of what volatility is occurring in the world. As a result, the ability to purchase protection on the market through a put contract is simply a click away!
That said, investors can still expect to pay a premium for insurance when market conditions are frothy in fear just like a homeowner trying to purchase a flood insurance contract would garner as a hurricane is rolling in. To get an idea of what that massive premium may be, an investor can gauge the CBOE Volatility Index (VIX), which measures the level of implied volatility currently priced in the S&P 500 options market. A VIX index in the 20’s is rather frothy, while levels closer to 10 is straight up cheap.
Unlike in the traditional insurance world, where the client is the home owner and the provider is the large insurance company, investors can take part in either side of the market transaction. That means an investor can decide that the premium is indeed very frothy and go ahead and sell insurance to another investor who may be more concerned and is looking to protect further downside.
The ability to play the role of the insurance seller opens up a plethora of investment opportunities. For example, let’s say an investor decides they would like to buy into future market weakness. They may decide that if the market drops 10% from current levels, they would have an interest in investing further into equities, either by using cash or selling fixed income. During the volatile market period in December, a put struck 10% below the market was typically yielding between 6% and 12% on an annual basis, depending on maturity and when struck. That is a nice premium to collect. If the market rebounds, the investor generates a nice yield. If the market ends up dropping to or below the level, the put seller becomes an owner of the market at a level equaling the strike price of the put sold less the premium collected.
In addition to being able to offer insurance on individual securities with active option markets, such as Apple, Facebook, and others, an investor can also construct option strategies that take advantage of high premium levels, while limiting losses. For instance, an investor can sell the 10% downside put described above but then purchase a lower put; let’s say 15% below the market to limit potential losses to 5%, while still capturing a yield, albeit lower, on the market. It is the equivalent of purchasing the market at a point in time with a stop loss below.
In summary, investors have the unique ability to play the role of insurance provider within the financial markets. When markets are frothy due to fear driven selling, premiums tend to expand materially. Given an interest in purchasing the market on further declines, a put sale can be a nice way for investors to collect premiums, which may be viewed as a win-win. Moreover, it may help investors generate a nice yield if the market remains above strike levels or enables them to enter the future markets at a significant discount to current levels.