What is the price of “going short volatility?”

I’ve wondered about this question for a while.  Let’s say that bank manager/CEOs can play a profitable moral hazard game by risking that the lower left tail of the returns distribution won’t happen.  Write some far out-of-the-money naked puts, or more generally synthesize that position.  If you are a sports fan, imagine betting against the Washington Wizards to win an NBA title every year.  Most years you earn some above-normal profits.  Every now and then you go bankrupt.  From the manager’s point of view there are bonuses in the good years and in the bankruptcy year the worst that can happen is getting fired.  You might even be rehired rather quickly, if shareholders like such strategies too, at the expense of bondholders or taxpayers.  Think of that as a private arbitrage opportunity, albeit one with negative social value.

The question is, what happens to the price of that strategy?  Does it adjust to choke off more “going short volatility” at the margin? I see at least two options:

1. The return from writing a naked put (and related synthetic positions) falls somewhat, as many banks play that strategy or would play that strategy if the prices of the relevant bets did not adjust.  What is then the story for the market as a whole?  Are some of the “moral hazard gains” shared with those who buy naked puts?  Why should the “tax incidence” problem stop there?  Where exactly in the system do those gains come to rest?  For sure there are gains to the early users of this moral hazard strategy, but once market prices are adjusting where do the gains go?  Can excess returns be seen in observed securities prices?

Of course that there are *many* synthetic ways of writing the naked put or shorting volatility.  Do the prices of all of them adjust, over time, as the early users of the strategy scurry from one opportunity, see it closed off by price shifts, and then move on to the next?

The cynic will think that hedge funds are doing well on this one.

2. Perhaps some banks play this strategy but their trades, relative to liquid markets, are not big enough to push around the price.  Or maybe arbitrage is too strong and it keeps securities prices in line with standard theory.

Imagine that the fundamental value of a security was $40, but a beautiful woman would give a trader a kiss every time he bought the security, bringing his net private return to $41.  Due to arbitrage and short sales, the price of the security will remain at $40, although the private gains will persist from the purchases.

In the latter case banks can’t raise enough liquidity to budge the market price, relative to the power of the other side of the market.  Along related lines, legal and institutional constraints may limit the “short volatility” strategy and also blunt the effect of those strategies on market prices.

Which case is better/worse for the world as a whole?  Does it matter for financial regulation which case is true?

I thank an anonymous hedge fund manager for a conversation on this topic, Interfluidity as well.


The conventional wisdom is gambling markets is that the pricing goes the other way around, i.e., that longshots are overpriced and pay below-market returns. That is, over time, you would earn excess returns by betting every year against the Wizards' winning the title.

In the sports betting market, high transaction costs (bookies take a big cut of the total wagers) may enable pricing irrationalities to persist. If the people who bet in favor of the Wizards lose 10% a year, and the people who bet against the Wizards break even, then you have an equilibrium. But in financial markets, transaction costs are much, much lower. So the analogy breaks down at this point.

Well, most books will not even let you bet against the Wizards to win the championship. What would the odds be, 10,000-1?

But sports betting is not supposed to be an investment. Books are pricing primarily for recreational players, who are betting for fun and prefer occasional large payouts.

This post sounds interesting. Perhaps it could be translated into less telegraphic/less technical language.


For now, I'm filing it under "Questions I don't understand"

Writing cover options may increase yields. Writing naked options entails huge risks. Counter-party risk would be huge. Too much leverage, no capital protection. Margin requirements?

Writing "covered" calls make the concept a bit easier to understand. I own IBM at amortized cost $85. It trades at $90. I sell a $90 call option and am paid a $2. I have $2 income (accounting) and if the price goes over $90, the option will be exercised and I will have an additional capital (maybe) gain of $5. I'd rather not have the option exercised. Here the major risk is if the price goes to $120, the option is exercised and I lose out on the $30 additional gain. If I wrote the call naked my loss potential would be the cost of the securities I deliver: 120, less the option premium $2 less the price of the security I deliver $90 = $28 LOSS.

Relatively high risk = writing naked. They usually offset that risk with another option, swap or whatever.

Sounds complicated.

Maybe I'm missing something. Here's how I see it. "Buy low. Sell high." I "write" the risky put option. The option buyer pays me to buy at a set price over the next say 90 days. Then, I am obligated to meet the option holder's (he has the discretion and I must meet it) put demand: I will need to buy from him at a price favorable to him: it's his option. My gain/loss (adjusted by the option price I received) is dependent on the market. My gain is the option price plus (here's the speculation) if I buy at a profit while the put holder would lose.

My potential loss is relatively unlimited, while my upside is limited to the put premium. Why would the put owner buy from me at the less favorable option price?

And, I don't see how there is "moral hazard" unless we have the politicians providing liquidity and skewing asset resources allocation, or bailing me out.

The AIG CDS payouts seem like an example of such moral hazard http://www.nakedcapitalism.com/2009/10/fed-authorized-100-payout-by-aig-on-cds.html.

That was the intent of the 'betting against the Washington Wizards' analogy -- (or better yet would be betting against the Washington Generals to beat the Globe Trotters).

But it's probably easier to understand the real life example of the housing bubble. The bursting of the bubble wasn't really a 'black swan' event. A lot of people knew it was a bubble that must eventually deflate (and not in the distant future either). But even so, as a fund manager, it was advantageous to jump in even though you knew it was a bubble because in the boom years, you make huge bonuses. When the bust comes, your stock and bond holders may be wiped out and you might lose your job but you get to keep all the money you made up to that point.

Why doesn't the market correct for this? In reading The Greatest Trade Ever it was revealing just how hard it was for professional fund managers to bet against housing during the bubble -- both because 'the market can stay irrational longer than you can stay solvent', and because the right investment vehicles weren't really in place (in sufficient quantities). John Paulson actually had to push firms to create more of the credit default swaps that he used to make his big bet against housing.

And, of course, one of the takeaway lessons from the crash is that 'exotic' financial instruments are evil, so the tools needed to bet against (and, therefore, possibly prevent) the next bubble are unlikely to be available when needed.

What if a significant chunk of your bond holders are also short-horizon investors expecting to jump off the wagon before the boom ends? I think this is a fuller description of some of the events.

Sure -- some of the investors were also aware of the game (and many who weren't, were bailed out anyway).

Also, a fund manager who participated in the bubble might lose his job when it burst, but a manager who refused to play would the risk of losing his job much sooner (as his funds returns did poorly compared to others). Bad incentives all around.

i'm skeptical that this problem is larger than the problem of not being able to estimate risks for events outside the historical data/traded market price information.

for that matter, how many non-bank firms/individuals correctly estimate and manage their tail risks? is every company put out of business by new technology (eg Kodak) guilty of not correctly forecasting their risks (digital cameras), or of taking advantage of moral hazard (by not investing enough in R&D or by running a business instead of investing in treasuries)?

This was basically what the guys at Long Term Capital Management did!

Actually I think this oversimplifies LTCM's strategies. Most of LTCM's positions made money after they were liquidated, they just couldn't continue to post margin to hold the positions until they came back into the black.

Most of their strategies were things along the lines of shorting the current on-the-run treasury in the series and buying the less liquid off-the-run treasury. The latter tends to trade at a slight discount to the former, so one who does this is guaranteed to earn a small time premium if held over a long enough period.

During periods of low liquidity the spreads widen, because investors put a higher premium on liquidity during times of crises. So in that sense it's like selling naked puts, because you mostly make small amounts of money consistently, than have occasional large drawdowns. The difference though is that if you're writing naked puts and you lose money one month, there's no guarantee you'll ever make that money back. For LTCM's strategies they were basically guaranteed to make back all their losses if they could have just posted margin.

a broken clock is right twice a day. The objective is to make money BEFORE you go out of business not at some unidentified point after that

Generally in financial markets it seems like volatility is overpriced rather than underpriced. Like you say in your post it's hard to tell because your losses are highly skewed. However if you look at 2000 to today, a strategy of selling options on the index (or more recently selling VIX futures or the VXX/VXY etf) and delta hedging would have made money.

Not if you had put 100% of your wealth in the strategy, but Kelly sized correctly (~10-20% of one's net wealth) you'd have done pretty well. Certainly much better than buying the index itself. You would lose a lot in late 2008, when realized spiked to ~50-60% when the VIX was 15. However from 2008 to early 2011 the VIX was consistently higher than realized volatility. Many months by 20% or more.

I agree with you there's an underpricing bias to volatility from people trading other people's money and not caring about tail events. However there's an even stronger overpricing bias from highly risk averse people, or people who want to hedge for the states of the world when volatility spikes. Buying VIX futures or buying puts as an incredibly popular hedge for an incredible number of money managers.

>>>Generally in financial markets it seems like volatility is overpriced<<<

As a layman, I'm curious: Is this a subjective perceptions based assessment or is there some objective quantitative baseline to price against?

There are plenty of studies on the volatility risk premium. For example:
Or you can get a rough idea of the overpricing by looking at the gap between implied and realized volatility. Doug is dead right - as I know from selling vol during the past four turbulent years. You can lose big at times, but the profits rebound quickly after the tail event if you aren't shaken out.

Would you earn above-normal profits for betting against a long-shot in most cases?

This is a great post for understanding the incentives for folks at companies like Lehman or AIG pre-2008 – There is probably some threshold where the gains made by managers for making these bets are so great, the costs of "getting fired" or losing the opportunity for future employment may not really matter. In a sense the potential value of lost income (post crash) may decline after one reaches a certain wealth level. For those who walked away with hundreds of millions from Lehman etc., the system worked even though their companies went bust. Embarrassment and social stigma aside, if this is the case why shouldn't people continue to make those kinds of bets as long as markets reward the behavior?

Isn't that just the principal-agent problem? Misaligned incentives and all that?

yes - but in this sphere it has far reaching consequences -

Will markets adjust to fix it?

Does Dodd Frank help?

Whatever incentives the market or regulators might have to fix it; shouldn't the incentives of the principal itself (Lehman, it's shareholders etc. ) be the greatest to fix it?

sure, but there are big collective action and information cost issues

Basically that's financial innovation, finding ways to write puts in ways that aren't heavily regulated, yet.

If you are selling the shorts these folks are buying, you need to be concerned about their solvency. Or, be the government.

Wouldn't the market price have to take into account the implied counterparty risk (the bankrupt bank can't pay). Implicitly then, the perceived likelihood of a bailout can affect the price dynamics of such a bet with the price being largely determined by what investors believe will happen when a market event comes along akin to the Wizards winning the NBA championship.

Buying AAA MBS to satisfy cap ratio rules is not "short vol" so much as it's "regulatory arbitrage". I guess technically a long position in almost any security could be called short vol since asset prices generally decrease when riskiness or perceived riskiness increases, but the question makes it sound like managers are actively making a decision about taking tail risk when most likely they simply had no idea it really existed.

AIG on the other hand was actively taking tail risk, but that is their primary business as an insurer. They clearly weren't managing the risk appropriately if they had enough in one business unit to bring down the entire firm. I still think the most likely explanation is the simplest- incompetence.


You pose an interesting question, but I'm not convinced that the practice of selling the left tail is that prevalent. Berkshire Hathaway and AIG used to do so, by selling puts on equity indexes and housing-related securities, respectively. Both, however, are no longer doing so. I work in financial markets and don't often hear of banks or others engaged in naked put writing. I think option skew reflects this fact, as prices for downside protection and long-dated variance are extraordinarily high.

Excellent post. My answer is: I have no idea. Which is the best answer to fun questions.

First, I think you need to distinguish between going short volatility as an explicit insurance exercise (e.g. knowingly operating an insurance company) and going short volatility as a result of principal/agent and governance failures (e.g. unknowingly operating an insurance company.) Obviously, even an insurance company can have both!

In the context of the latter, I would re-phrase the questions as the following:

1. Is enough capital allocated to investment operations with fundamentally bad enough governance to allow efficient pricing of short vol strategies?
2. Do arbitrage profits exist for agents such that they can extract riskless profits from the use of principals' capital?

The quick answers in my view are no and yes. There aren't enough hedge funds with enough assets to accomplish #1. And, the compensation structure of hedge funds, combined with the continued growth in hedge fund assets seems to indicate that #2 must be true.

A hedge fund is not a compensation model. It is a governance model. A hedge fund is a corporate structure with the legal minimum governance. Thus, hedge funds are very well suited to take short vol bets. The ultimate asset owners have no vote, except by their feet, and only if the managers doesn't impose arbitrary constraints on voting with their feet, (e.g. gating redemptions, etc.)

Furthermore, by design, hedge funds collect short vol premia, within some self imposed (non-binding) constraints, when the manager believes it is appropriately compensated. [Try to think of a hedge fund strategy that is not short liquidity...a portfolio such that long positions are more liquid than short positions.]

Institutional investor here. Something to think about: a recent working paper from Jakub Jurek and Erik Stafford, "The Cost of Capital for Alternative Investments", suggests that the risk profile of the aggregate hedge fund universe can be replicated by a simple naked put writing strategy on equities. Arbitrage strategies in general tend to have the payout profile of put writing, i.e. they clip coupons until collapsing when liquidity dries up (which coincides with equity drawdowns).

Also, in response to an above post, equity puts are only "expensive" because there are no natural buyers for downside equity risk. Asian markets are fundamentally different in this regard as Asian banks structure retail products around put writing, matching option implied return distributions much more closely with historically realization (HSBC in Hong Kong offers "equity linked CDs" at 15%, compared to cash at 0.1%). This retail market comes from cash returns near zero for the past two decades. If rates remain low in the US/Europe for an extended period of time I would expect similar retail "Equity-based CDs" emerging.

Markets are not efficient. People herd. Markets aren't linear, they are exponential. Small actions create larger actions, not a counter-response that pushes the market to equilibrium.

I have heard both Hugh Hendry and Kyle Bass speak publicly on the low cost of taking the other side of the trade. Some bets have become expensive (euro region), but I believe it was Bass in 2011 who said he was able to buy bets against Japanese bonds for about 1 basis point. Hugh Hendry spoke of a trade that had something like a 40x payout.

The past 30 years is sort of an historic anomaly. Credit bubbles and bull markets don't usually run this long, and thus far every bailout (up until EFSF) has "worked" in raising/stabilizing asset prices. On one side of the table are the banks writing these trades, with access to bailouts and central bank funding. Almost everyone involved wants low volatility: voters, governments, bankers, central banks. At the other end are investors with the capital they bring to the table. This type of trade can win in the long-run, but you need staying power. You have to pick your battles for most of the time, until the governments, bankers and central banks exhaust themselves. Then the cost of volatility goes to infinity as many of these institutions cease to exist (at least in current form).

What's the price of deficit spending for a politician?

I think that the moral hazard actions of bank manager/CEOs isn't where the real action is. The biggest "seller of volatility" is the Fed and other institutional actors (consider Fannie, Freddie, QEII, etc.). (I have always wondered why the Fed didn't auction straddles on asset prices instead of outright buying assets when they want to restore "confidence" -- a separate, but related, topic). Volatility and liquidity are closely related. As perceived volatility decreases, perceived stability and perceived liquidity increase and funding costs and perceived incentives to gather private information decrease (e.g., auction-rate securities, money-market funds, "Greenspan/Bernanke put", bailouts, etc.). Ceteris paribus, lower volatility should lead to higher asset prices and greater perceived solvency. When private actors pull back in a financial panic, governments frequently step in. Whether these actions reflect a desire for (1) lower volatility, or (2) lower volatility of volatility, (3) lower funding costs, or (4) public choice issues is an open question.

So what are the "right" (or even "desirable") levels of volatility, perceived stability, perceived solvency, and liquidity at any given time? That depends on the trade-offs between the "stimulus" benefits of manipulating perception of risk downward (higher asset prices, lower funding costs, lower volatility, greater risk-taking, less insolvency, etc.) versus the costs (less information/feedback in markets, misallocated investment, etc.). Unfortunately, these are political questions as much as economic questions. Based on the frequent actions of public actors to subsidize market risk and the high level of current activities in this regard, I would not expect financial regulation to target sellers of out-of-the-money puts or similar strategies. If regulators were seriously interested in limiting moral hazard by financial managers and corporate malfeasance/theft, MF Global would provide an excellent opportunity -- so far, the regulators have passed...


Interesting question, but I think there is no simple answer, as there are many complications I can think of off the top of my head. I once traded options for a large firm, so some of these points may be limited to the options markets and not other more obscure ways of shorting vol, but I suspect they would apply generally as well.

The first has to do with the lack of liquidity for most of these far out of the money (OTM) options. Since the world is net long financial assets, you might expect there to be many natural buyers of protection, and indeed many think that OTM puts are priced slightly higher than fair value due to these buyers, but in practice there are not really all that many buyers of these puts relative to the size of the whole market. On the floor, if someone asked for a market in these far OTM puts, it's true (assuming it is an opening and not closing transaction) that you can be pretty sure that he wants to buy and not sell them, but such requests happen infrequently. So the response of the traders, expecting to sell and also probably already being short anyway, is to make the market, say, .25 bid at .50 ask, when they think "fair value" is maybe .30, if not even lower. Since everyone expect the customer to be a buyer, they all go along and get to sell some of the options at a price closer to .50 than .25 and are happy to pocket the extra money. If someone came in and started hitting the .25 bid, the market would quickly change to something like .10x.25 for as long as sellers are coming in.

Note also the relative size of the spreads for these options. Markets in near the money options in liquid ETFs like SPY can be very liquid and tight themselves, but for thinly traded way OTM options the spreads can be quite wide, especially relative to their naturally lower prices. But only part of this wide spread is due to their liquidity, another factor is the simple uncertainty of pricing their fair value. It is much easier to price a bunch of near the money options than a bunch of way OTM options. One can price NTM options such that you can play a repeating game of buying and selling them and be reasonably sure you will make something close to your expected value (difference between fair value and transaction prices) after many trials. This is not at all the case with the options that capture tail events. No one really knows what the fair prices are, and even if somehow the fair price was known, even after many trials you would not expect to end up with the difference between fair value and what you paid for the option. Moreover, even after many years of trials you still wouldn't even know if your initial estimate of fair value was even close to right, no matter if you ended up with zero dollars or billions.

Thus the spreads, and the speed they adjust with demand, make it difficult and unappealing to try to put on a big position. I guess one way of looking at it is that demand is very inelastic, whereas supply is quite elastic. There are some parties who want to buy a certain amount of protection, and over a wide range of prices they are still going to buy the same amount. Thus the banks, traders, hedge funds etc all end up short a bit of this risk, at an attractive price, but if they wanted to get short a lot more than the natural buyers demand, they would have to sell to each other, and the seller would only find bidders willing to pay a much lower price. Now certainly there are some parties in the financial space more willing to bear this risk than others, or to bear it at a lower price, so a larger share of the positions would flow to them, perhaps by selling more to another bank who is hedging their own exposure and locking in a profit, but there is a limit to the net notional value of such bets the market will bear before prices collapse.

Remember, as you pointed out in your post, if you are naked short a ton of this risk you do well most of the time and blow up occasionally, but symmetry means that if someone took the other side of that trade they would lose most of the time and occasionally win big (even then, only if they can collect from you, which makes this tack even worse). Just as moral hazard makes selling the risk potentially attractive, there are very few parties that like returns that buying the protection provides. Sure, occasionally you get a Paulson, and certainly there were many would be Paulsons who were early to the trade and lost too much early to keep going, but even in Paulson's case he was not blindly going long general market tail risk in normal times, he was getting short a specific sector at a carefully chosen point in time. That there are few stories of large institutions winning huge sums by being long far OTM puts in the market crashes over the last decades would seem to indicate that either there are no such large sinks to hold such protection, that there are no large sources of naked selling that risk, or at least the buyers are spread out enough or engaged only in hedging other positions to not register a big win.

Think about another synthetic way of selling tail risk in one of the many examples of basis trades. I think that to the extent you see banks go short vol it would be in piling extra leverage on such trades, simply because it is a more liquid market with more natural trading. Also, I suspect that the returns on capital are greater, if for no other reason than relatively more attractive regulatory requirements. Depending on how far out of the money strikes you look at, I'm not sure that the return on naked selling puts is necessarily all that attractive given the margin requirements. Another issue with the simple example of shorting puts is that, like LTCM, you could blow up due to marking to market on a much smaller down move than is necessary to make your puts in the money. So even if you would have won if you were able to hold the puts to expire worthless, they could easily explode in value on a dip large but shallow relative to the strike price of your puts.

It is for this reason I think things like leveraged basis trades (and who knows what other complicated structured we don't yet know about because they have yet to blow up) are where this moral hazard is reflected. And in the case of basis trades, wouldn't the "moral hazard gains" be shared diffusely by the overall market, as the marginal counterparties on both sides of the bank's trades get slightly better prices, whether they are a corporation selling bonds to borrow funds or transacting in currency to hedge sales, or a pension fund selling out of its holdings? Although I still suspect that these diffuse gains are dwarfed by the spreads, fees, commissions, etc that the banks are already extracting from everyone else.

The answer is problematic, because the main activity of a bank or a hedge fund can be thought of as providing liquidity to those who need it. Financial intermediation, that is. On the one hand, this activity is clearly short certain kind of volatility. and yet can be long certain other kind of volatility. For example, a VC is long the volatility of a particular investment but short the volatility of the overall macroeconomic situation in the world. A bank that lends money to a bridge builder at 7% interest is short volatility. So, my point here is, the last thing we want to do is regulate away being short volatility

In fact, what we want to do, is generate automatic stabilizers and "equalizing institutions" ( such as good education, etc. ) and regulate as little as possible outside of those two things

I think if your government's economic policy becomes one of blowing bubbles, and this is a fair though oversimplistic description of US economic policy for the last couple of decades, then as an investor you have to go with the bubbles. Until the bubble bubble finally pops.

The answer to all your questions is AIG. And derivatives. In the end AIG collapsed because they were forced to put up margin on their-then naked 'short volatility' trade. And no, no bank would have survived AIG's bankruptcy because no other bank had the balance sheet to insure the giant holes in your trading book where supposedly solid-as-good credit default swaps were just yesterday. If you care to google, Goldman's defense of itself in 2008 was that AIG's bankruptcy wouldnt affect them because they bought CDSs on AIG from...Lehman Brothers. Which is, of course, comical.

"Sure, occasionally you get a Paulson, and certainly there were many would be Paulsons who were early to the trade and lost too much early to keep going, but even in Paulson’s case he was not blindly going long general market tail risk in normal times, he was getting short a specific sector at a carefully chosen point in time. " This is actually wrong. Paulson's trade specifically was not a naked short. By buying credit default swaps instead of naked shorting specific names or even an index Paulson had an extremely limited downside. In fact that was one of the major points of the crisis, the guys who went short the market were amazed that financial institutions were willing to insure risk of default of tens of millions of dollars of CDOs for pennies on the dollar. One of Paulson's hedges cost 100,000 USD a year to maintain and insured a 30 million CDO.

The people who were selling him these products were going short volatility.

more #1 than #2, the option price is just indicating the expected vol of the underlying based on the demand for options. When you a buy a stock you are taking the same left-tail risk as when selling a put. The problem arises - as in most speculative ventures - with the implied level of leverage. This, and not so much the long theta position is what allows the larger returns and eventual blow-ups. (Plot expected returns of selling cash-secured puts to see what I mean) This makes short-vol moral hazard similar to most others in the financial markets. Most participants have stringent margin requirements from the broker/clearing system, have decent incentives for not blowing up, and don't pyramid synthetic leverage (of the short option) on top of already over-levered balance sheets. For a seller of tail-risk there is a buyer, and price adjusts. It gets more complicated with some of less-obvious ways that firms underwite tail-risk though.

Higher vol = higher premium(profit) = higher implied propability of an out-of-the-money option expiring in-the-money (or an ITM option expiring OTM). So in theory there is something of a trade off between the level of returns and the frequency of tail-events, assuming imp vol is at the "correct" level. Of course it's not: 1) it responds to human emotions/irrationality like any other market price 2) it's impossible to accurately predict what realized vol will be and 3) option pricing models are still imperfect and the attempt to model financial markets foward still has serious pitfalls.

So yes, if everyone decides one day to underwrite tail risk, the returns from this strategy will be lower for everyone going foward. In reality this doesn't happen and large vol traders aren't thinking in terms of the monthly or yearly returns from this type of strategy, but rather whether they feel vol is cheap or rich (usually against some other asset or index, but also in general) based on a number of factors.

Debt is an out of money put......core financial economic theory.....

Lending is writing puts, borrowing is buying them.

In our system value does occur to the buyers, via lower interest rates than what they would pay in a true fair maket without fin insto tail risk absorption.

Noting that the best banks actually do value some loans using option methodologies (i know, I work in a big bank). Banks as a business are already massively short tail volatility via the loan book,

Given reasonable assumption that tail risk world states likely lead to high or increased correlation of assets, derisking the bank system via forcing banks to BUY deep out of money volatility protection might be a solution to bank system risk (thigh ultimately someone must wear and price that risk - govt? Thereby acting as a quasi tax).

But ultimately, any move like this, which while it does derisk the banks, it is expensive and in equilibrium part or all of that expense wil be passed into the economy via higher interest rates.

But uly

It gets worse. Because fund managers and traders compete with each other within their organisations and there is minimal difference in inherent performance, only those who follow this strategy will consistently succeed (barring the odd bankruptcy event). Those managers/traders who do NOT follow this strategy will therefore get fired during the good years.

Also note the complete lack of managers/traders being fired when they screwed up recently, and really there is a very heavy hand on the scales on the side of pursuing these known-high-risk strategies.

"Sell a teenie, lose your weenie"

In my experience whatever institutional bias there is towards writing naked puts is totally wiped out by general risk aversion and I think the data suggest that OTM options are overpriced not underpriced.

From personal experience whenever I bring something to a trader that is OTM in the markets that I work in they tell me to jack up the price.

Concur with the other financial industry practioners here. In the real world people exhibit a consistent bias toward large upside, capped downside pay off curves. It is true for lottery tickets/horse races, general insurance policies, stock prices and derivative markets. The article referenced earlier by HH is well worth a read on this point.

Obviously not everyone is wired exactly the same way (that's what makes a market) but payoff curves with unlimited potential downside for a relatively small, fixed upside are systemically undervalued in a large number of markets. This type of payoff curve is inherently uncomfortable for most people (and boards, managers, etc.) and is avoided to the point of permitting outsized returns. Previous commentators are correct in identifying hedge funds as net beneficiaries of this in aggregate. Incidently the point raised earlier about the difficulty of shorting the US Housing market is consistent behaviourally from the individual investment managers's perspective, where lose big (the downside to be avoided) = losing your job/life style by being wrong on timing when everyone else in the industry is "right".

This topic is an interesting question but the reason you can't come to an obvious/logical conclusion is that the starting premise that smart guys in the real world have a preference for being short vol is on my reading of markets and empirical evidence not actually true.


One of the best papers I've read recently.

If there are multiple ways to achieve the same result then, subject to transaction costs, liquidity and hurdle issues, the pricing of all of those methods should adjust simultaneously even if only one of them is actually being implemented (hey - you either believe in markets or you don't).

If a banker writes a naked OTM put:
a) in a real sense he is not just short volatility he is long the underlying security;
b) it should bid down the price of the put, bid down the implied volatility and bid up the price of the underlying security.

The losses from the moral hazard go to the shareholders and creditors of the bank. Statistically some of the gains go to the shareholders and creditors, some goes to the bank employee, some go to the buyers of the puts (who get cheaper downside insurance), some goes to the holders of the underlying security who may get a small temporary increase in price as a result of the writing of the put. If puts written by the bank are generally over-priced then the shareholders and creditors holding bank shares or bonds as a small part of a large diverse portfolio might benefit from the moral hazard play. At some level such shareholders may actively encourage the moral hazard play because they have a very effective stop loss in place in the form of statutory limited liability.

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