There have been a number of experts warning that the stock market is due for a crash. There’s always people saying that, but it seems to have picked up since the summer. I don’t know anything about this; my crystal ball was stolen by a dark elf. But the possibility of a sharp decline is what makes the rest of this post interesting.

One trading strategy is to sell put options. You can sell puts on individual stocks or on an index. (Or anything, really). In exchange for a payment, you agree to potentially purchase some asset at a fixed price until the option expires. A put option is essentially insurance. Selling a put is the same as insuring an asset against a decline in value. To pick a stock I have no particular attachment to, MMM is currently trading around $180. If I’ve got a cool $17500 cash lying around, I might sell a one month put option with a strike price of 175 at $1.00. I’m predicting that MMM will do alright in the near future, so if all goes according to plan the option will expire worthless and I’ll pocket an easy $100. That’s an annualized return of 7.0%. Ignoring downside. (Option contracts are for 100 shares, hence the 100 x 175 cash requirement (in the event I’m forced to complete the purchase) and 100 x 1 income.)

This is what a WSJ article, In Scramble for Yield, Pension Funds Will Try Almost Anything, is all about. “Pension funds in Hawaii and South Carolina are plying an arcane options strategy called cash-secured put writing.” I would not however characterize this as an “arcane” strategy. It’s one of the four most basic strategies: you can either buy or sell a call or a put.

This is claimed to be a way to cushion the fall in a down market. The income from selling the options supposedly compensates for losses in the rest of the portfolio. However, as Matt Levine puts it, “That is ... not how puts work? Selling puts increases the funds’ downside risk if stocks fall; if they want to protect against a stock drop, they should buy puts.” Of course, as the WSJ headline notes, what the pension funds really want is profits. If you’ve got a bit of cash and don’t think you can get the desired return by buying stocks, selling puts is a short term means of collecting money. In a follow up article Levine notes that the VIX index is historically low and connects this with the behavior of the pension funds.

The VIX, or volatility index, is a synthetic ticker that’s defined in terms of predicted market volatility. Of course, it can’t be backwards looking, that wouldn’t do any good. But how can it be forward looking? The answer is that it’s calculated from the current market price of options on the S&P 500. It’s a measure of the implied volatility based on option prices. (Of course, one can trade options on the VIX itself. Turtles all the way.)

This means that the VIX is indirectly subject to supply and demand. If lots of people are selling puts, the price will decline. But if the VIX is low, markets will look stable, so fewer people will be interested in buying puts, thus pushing prices down more. Enter a few pension funds with too much money, and...

What’s interesting (or alarming) is that pension funds will be attracted to this trade exactly when they shouldn’t be. As the stock market peaks, returns will drop. Buying more stock with their cash isn’t appealing. Unfortunately, when the correction finally comes, the puts substantially increase their exposure.

In 1987, a similar strategy was in vogue. Portfolio insurance. Just keep selling short futures to offset stock losses. It didn’t quite work out.

Something similar also happened in Japan towards the end of the 1980s. Everybody knew the Nikkei stock index would never stop going up, so people looking to make a little side cash sold warrants (options) pegged to the value of the index to investors foolish enough to buy them. And then Gordon Gekko meets Godzilla.

If the funds are tired of waiting for stock prices to go up, why not sell call options instead? Probably for fear of missing out on possible gains. As noted, they aren’t really hedged against a downturn. They’re still optimistic.

Being a little short but not short enough is a recurring theme in finance. (Mostly because simplistic Value at Risk estimates don’t work well.)

From The Big Short, Howie Hubler at Morgan Stanley predicted a BBB rated collapse and bought $2 billion in insurance, but to pay for it he sold $16 billion in AAA rated insurance. When the collapse finally came, he wasn’t $2 billion short housing bonds; he was $14 billion long. “He was smart enough to be cynical about his market but not smart enough to realize how cynical he needed to be.”

Or a bond trader who had a slightly more complicated position, but was generally positioned to profit from a decline in bond prices. And he did, for a while. Except uh oh. “He seemed to have positioned his fund to bet against the bund, but as events worked out his bet against the bund seems to have been swamped by an offsetting bet on the bund.”

Or similarly with the London Whale, “who tried so hard to bet against corporate credit that he ended up betting massively on corporate credit.” That didn’t end well either.

Now we’ve got a bunch of pension funds with positions designed to profit in case the market goes down a little. But only a little, not a lot. How will this turn out?