Abstract
Undiversifiable (or systematic risk) has long been an enemy of investors. Many countercyclical strategies have been developed to counter this. However, like all insurance types, these strategies are generally costly to implement, and over time can significantly reduce portfolio returns in long and extended bull markets. In this paper, we discuss an alternative technique, founded on the premise of physiological bias and risk-aversion. We take a behavioral discussion in order to contextualize the insurance like characteristics of option pricing and discuss how this can lead to a mispricing of the asymmetric relationship between the VIX and the S&P 500. To test this, we perform studies in which we find statistical inefficiencies, thereby making it possible to implement a method of hedging index option premium in a way that has displayed no monthly drawdowns in bullish periods, while still providing large returns in major sell-offs. The three versions of the strategy discussed have negative betas to the S&P 500, while exhibiting similar risk-adjusted excess returns over both bull and bear markets. Further, the performance generated over the entire period, for all three strategies, is highly statistically significant. The results challenge the weak form of the Efficient Market Hypothesis and provide evidence that the methods of hedging could be a valuable addition to an equity rich portfolio for the purpose of counteracting systematic risk.
Highlights
Recent developments in the behavioral sciences have shown that losses create a negative physiological impact of approximately double the magnitude of the positive impact we would experience from an equal gain
We show that these strategies have been consistently profitable through a range of market conditions, arguably due to the failure of the market participants to accurately price in this asymmetric relationship
It is clear that prior outcomes influence investors risk aversion in market sell-offs
Summary
Recent developments in the behavioral sciences have shown that losses create a negative physiological impact of approximately double the magnitude of the positive impact we would experience from an equal gain. As an alternative to this, we put forth that: (1) loss aversion is likely to drive the VIX to spike more than it “rationally” should during a market crash, as it causes market participants to evaluate the probability and weight of future outcomes incorrectly, which increase the demand for insurance (put options); and, (2) prior to such an event occurring, positive market developments may frame the choices and lead to market participants underestimating the likelihood and psychological impact of an extreme event. This study examines whether this alternative hypothesis can be substantiated, and if so, understand whether such strategies can be used to combat systematic risk on a month-to-month basis
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