Increased Demand for Portfolio Insurance

By Jeffrey N. Saret and Lauren M. Sholder on December 15, 2015
picture of a stock broker looking at a screen

A form of portfolio insurance has grown more expensive recently. Multiple potential causes exist, from regulatory changes to fears about the global outlook.

Portfolio insurance proved all the rage during much of the 1980s. Equity market participants bought put options on the S&P 500 with the hopes of limiting their downside risk while still capturing most of the potential bull-market upside. The strategy’s fame quickly turned into infamy, however, when many market historians blamed some of the 1987 crash on portfolio insurance and automated trading.

Today, portfolio insurance has become more expensive as investors and financial intermediaries like banks have more widely adopted the strategy. The relative skew of put versus call options on the S&P 500 index has sustained levels during past 18 months far higher than the ten-year average. At times, the skew has reached two standard deviations above the mean. On average, the skew exceeded 1.2 standard deviations. A qualitatively similar pattern exists for options on the Russell 2000 index.

rolling 1 month Z-score of implied volatility of puts over calls in the S&P 500 and Russell 2000 indices
These figures capture changes in the skew of the volatility of a put option relative to that of a call option after controlling for the distance from the at-the money level, illustrating how market demand for downside protection – a form of portfolio insurance – has shifted over time. Download full article for details.

What’s driving higher demand for portfolio insurance?

Multiple potential explanations exist. New regulations and assessments in the United States, including Dodd-Frank and the Comprehensive Capital Analysis and Review (CCAR), may have structurally changed the market by both forcing banks to better hedge their equity exposures and withdraw from their historical role as liquidity providers. For example, banks prepare for the Federal Reserve’s annual but increasingly important CCAR test by stockpiling put options to try to demonstrate that their equity positions could weather market stress.

More worryingly, equity market investors may feel apprehensive about the global economic outlook, inciting them to purchase greater amounts of portfolio insurance than during the recent past. Either way, the relative skew of put versus call options implies that the demand for portfolio insurance has increased relative to the supply.

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The views expressed above are not necessarily the views of Two Sigma Investments, LP or any of its affiliates (collectively, “Two Sigma”).  The information presented above is only for informational and educational purposes and is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. Additionally, the above information is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice. Two Sigma makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever.  For other important disclaimers and disclosures, download the full article.