Deep Out-of-the-Money Puts and Crash Risk Premiums
Summary
The document discusses a proposed options spread that sells deep out-of-the-money puts and buys puts closer to the money to investigate whether far out-of-the-money puts carry a crash risk premium. The response characterizes the short-put exposure as selling volatility and providing crash insurance, and points to Bondarenko’s research as a prominent reference on expensive puts.
It cautions that apparent returns can be misleading. Deep out-of-the-money options may be illiquid, with wide bid-ask spreads that erode results when positions are closed. The strategy may also earn steadily for a time but suffer severe losses during a volatility shock; the response cites pandemic-related market stress as an example. It offers no detailed rules for strikes, expiry, rolling, or position sizing, and warns that positive historical returns alone do not establish a safe or reliably profitable strategy.
Key ideas
- Selling deep out-of-the-money puts can expose a trader to crash risk and short volatility.
- A premium associated with disaster insurance may be embedded in these options.
- Wide bid-ask spreads can make illiquid options costly to trade.
- Strategies that collect put premia may face sudden losses during volatility spikes.
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Full text
# Option trading strategy to test crash risk premium # Option trading strategy to test crash risk premium I would like test if there are "crash risk premia" priced into out-of-the-money puts. My initial thought was to create a portfolio with a short positions in (deep) OTM put options and a long position in ATM or less-OTM puts. If this strategy would yield consistent positive returns, would this indicate that (deep) OTM puts are too expensive and that there is a crash risk premium / disaster insurance priced into them? Can anyone recommend papers on this topic or papers in general that describe the methodology of option trading strategies? I never really worked on a trading strategy based on options and there still are many small things I need to consider, i. e. when to roll them over or hold them until expiry, ... Thanks in advance! ## Answer by kurtosis (score 2, accepted) https://quant.stackexchange.com/a/57126 Does shorting DOOM puts yield consistent return? Yes*. (I'll get to that star shortly.) Is there a crash risk premium built into those puts? Yes. Are there papers studying these? Yes; many. Bondarenko (2014) is by far the go-to paper on this topic. In fact, you will see many citations of the paper throughout the expensive put options literature, even before 2014. His work became so popular that it was cited long before he published it. Some people have looked at these strategies and you are, essentially, shorting volatility which is writing insurance. Note that there is also an illiquidity premium for DOOM options which is itself harsh: if the bid-ask spread is 50% for people off of the floor, you need to make a lot of money to be ahead when you close out your position. That brings me back to that star qualifying the consistency of making money with such a strategy. The strategy can pay nicely for a while... and then bankrupt you quickly. A number of trading firms went out of business in days in the early months of this year due to pandemic lockdowns and volatility spiking up. I would not advise trading this strategy.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.