We wrote recently about the temptation of the 3-month 95% put on SPX, that rarely pays out. Investors choose is because it is cheaper than the ATM put but it rarely pays out unless you manage it actively. Another way of cheapening the put has been developed recently and makes the most of the elevated skew of SPX.
It consists in a regular put option that knocks out if the realised volatility observed across the life of the option is above a certain level. Ex : ATM Put on SPX with 30 vol KO will have the same payout of an ATM if the realised vol of SPX observed at maturity is below 30.
Setting the Vol KO at 30% cheapens the option by circa 40%. That is an extreme cheapening thanks to the steepness of the skew!
Indeed, current SPX 3-month skew suggests that the SPX should realise 30 if it goes down 10% and 35% if it goes down 20%. History shows that those levels are rarely reached. Since 2000, the 3-month realised vol is below 30 in 92% of cases. Exceptions being the financial crisis and Covid.
2022 is depicted as a volatile year but looking at figures for the SPX, we are in the 92% bulk (see red points below) with max vol of only 26.40. In other words, the ATM put with Vol KO is a very efficient way of buying a cheap hedge that performs well historically for “buy and hold hedgers”
That product is highly exotic and we will dive into it soon.
