Buying and Selling Crash Insurance (Tail Risk Protection)
February 18, 2016 - Equity Options
What are the best ways to buy or sell tail risk protection (crash insurance)? In his May 2015 paper entitled “Should You Buy or Sell Tail Risk Hedges? A Filtered Bootstrap Approach”, Lorenzo Baldassini uses filtered bootstrap simulations to estimate whether and how an investor can enhance an equity index return distribution (a buy-and-hold benchmark) by buying or selling index put options. He compares benchmark returns to those of the index plus one of the following four put option overlay strategies for investment intervals of one, five or 15 years:
- Static Purchase – iteratively buy put options as crash protection and hold them to expiration.
- Static Sale – iteratively sell put options to collect their premiums and hold them to expiration.
- Dynamic Purchase – iteratively buy put options as crash protection but sell and replace them before expiration if they appreciate above a set percentage threshold.
- Dynamic Sale – iteratively sell put options to collect their premiums but buy them back and replace them if they depreciate below a set percentage threshold.
He considers two values for each of the three overlay parameters used in the simulation model: (1) the budget for option overlay transactions (0.5% or 1.5% of portfolio value); (2) option maturity (3 or 12 months); and, (3) for dynamic overlays, option exit appreciation/depreciation threshold (50% or 500%). For the benchmark and each overlay variation, he runs the simulation 300 times to generate a return distribution. Using daily S&P 500 index returns and daily index put option implied volatilities for different expirations and moneyness during January 2003 through December 2012 to calibrate simulation inputs, he finds that: Keep Reading