Prospect Theory and Put Call Skew

I recently read a short piece of research that equated options volatility premium to “Prospect Theory”. I generally agree with this idea – that people pay (or overpay) for “insurance” unnecessarily because essentially they overweight the chance of loss. This manifests in options prices where you see “Put Call Skew” where put options are priced higher than equivalent call options.

Apparently (as seen below), this put/call skew didn’t really exist before the 1987 crash as you can see by the dotted red line. However after (solid red line) put options carried a higher volatility (and therefore value) than equivalent call options (equivalent based on a delta or percent out of the money basis). This fact, the pre and post ’87 skew fits into prospect theory, as after an historic, nasty crash people thereafter carried insurance.

Put Call Skew

Side note: demand for insurance whether its a market crash or earthquake usually spikes right after an event. For insurance companies, much like option sellers, this can be a great time to sell coverage.

Prospect Theory

There are many in depth articles on prospect theory. The summary of the theory is that people feel more “Pain” over losing money than making it. They therefore exhibit irrational behavior based on this emotion. The chart below shows that losing $50 is more painful than the joy generated from a $50 gain.

Prospect Theory Chart

This means that people will either overpay for insurance and/or insure unnecessarily. Umbrella insurance is a good example. The odds of a terrible event happening to you in which you need extra coverage is very small, but people still get covered.

Prospect Theory and Put Options

Investors worry about crashes and therefore there is more demand for put options than call options. Its not quite that simple nowadays in large part due to regulatory issues. Banks have to contend with CCAR (Federal Reserve Stress Tests) and small investors have to hedge margin risks, etc.This all drives put option demand that is not the result of Prospect Theory. Although, I suppose you could make a case that the Federal Reserve is victim of Prospect Theory by pushing stress tests onto regulated entities…

 

PE to VIX Ratio = Market Emotion?

I hadn’t come across this idea before, its a few years old but interesting.

From Arrow Capital:

PE/VIX = market emotion: lately drifting in and out of complacency
We define 5 categories of market emotion gauged by  PE/VIX:

1) Crash – very high VIX and low PE,

2) Skeptical/Denial – VIX elevated and PE still low,

3) Realistic/Disciplined – Both PE and VIX within normal ranges,

4) Complacency – low VIX or high PE or both,

5) Mania – very high PE and low VIX.