The World is Upside Down - When pension funds Sell volatility

Normally put options serve as protection for large, mainly long only, asset managers. Picture an investor committee meeting at a large pension fund in the wake of a equity market drawdown. The core portfolio is down, but the astute and prudent portfolio manager dodged the bullet by buying put options on the market or the funds' individual stock holdings. This is the way it would normally work, but there is nothing normal about the current market. 

A WSJ piece by Ben Eisen and Aaron Kuriloff this week alerts us to the topsy-turvy world of financial markets in an environment where the "reach for yield" is the only game in town. In short, in a desperate search for regular income and "yield" some pension funds in the U.S. are turning to the nuclear option of selling put options. I will let Eisen and Kuriloff describe the madness;  

"The upside for the pension funds, which are writing options on the S&P 500 index, is that they earn regular income. The strategy aims to work like a volatility dampener. If stocks fall, the income the funds have collected on the options contracts should help cushion any hit they take on the puts and their own separate stockholdings."

This obviously is blatant nonsense. In an adverse scenario, these funds will lose much more than the income earned on selling volatility. I really don't have any rational explanation for why pensions funds would do this. Just imagine the investor committee meeting where the portfolio manager has to report losses not only on the core stock portfolio, but also as a result of the added leverage due to the selling of puts. The issue has been discussed in the comments section of one of Macro Man's recent posts, and I cede the floor to trusty Leftback for the main points.

"This really needs to be nipped in the bud. What could go wrong? How do you even model the VaR involved? These trades really are binary. You either pick up another penny every day or you get obliterated by a steamroller."

I couldn't agree more, and in case you're wondering about that premium the pension funds are earning on the put options they're selling. Well, would you sell this chart?  I can't tell you when this will end, but I can tell you how; ugly! 

Hold my coffee while I sell some puts on Spoos