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I would like test if there are "crash risk premia" priced into out-of-the-money puts. My initial thought was to create a portfolio with a short positions in (deep) OTM put options and a long position in ATM or less-OTM puts.

If this strategy would yield consistent positive returns, would this indicate that (deep) OTM puts are too expensive and that there is a crash risk premium / disaster insurance priced into them?

Can anyone recommend papers on this topic or papers in general that describe the methodology of option trading strategies? I never really worked on a trading strategy based on options and there still are many small things I need to consider, i. e. when to roll them over or hold them until expiry, ...

Thanks in advance!

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Does shorting DOOM puts yield consistent return? Yes*. (I'll get to that star shortly.) Is there a crash risk premium built into those puts? Yes.

Are there papers studying these? Yes; many. Bondarenko (2014) is by far the go-to paper on this topic. In fact, you will see many citations of the paper throughout the expensive put options literature, even before 2014. His work became so popular that it was cited long before he published it.

Some people have looked at these strategies and you are, essentially, shorting volatility which is writing insurance. Note that there is also an illiquidity premium for DOOM options which is itself harsh: if the bid-ask spread is 50% for people off of the floor, you need to make a lot of money to be ahead when you close out your position.

That brings me back to that star qualifying the consistency of making money with such a strategy. The strategy can pay nicely for a while... and then bankrupt you quickly. A number of trading firms went out of business in days in the early months of this year due to pandemic lockdowns and volatility spiking up. I would not advise trading this strategy.

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  • $\begingroup$ You could argue that the positive returns are compensation for "kurtosis risk" ;) $\endgroup$
    – nbbo2
    Commented Aug 4, 2020 at 20:16
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    $\begingroup$ They absolutely are, but unless you are very well-capitalized, getting wiped out is likely. A number of highly-capitalized firms have been killed by such trades. $\endgroup$
    – kurtosis
    Commented Aug 4, 2020 at 23:57

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