My favorite way of introducing the idea of put options is the analogy to car insurance. The underlyings (both the vehicle and driver), the premium, the deductible, the max payout, and of course the term, all have contracting equivalents to the actual listed equity option market.
And we know our friendly car insurance provider never wins by more than the premium itself, rendering it short the accident. Geico is Citadel, studying its own version of realized vol with computations on accident and theft frequency and the financial costs associated w them.
There is a lot of data to mine including the cross-sections of drivers, cars, neighborhoods and (mis)behaviors. The game is the same: use data to sell auto insurance at an implied vol such that the premiums taken in outstrip the payouts and allow for an attractive return.
In the business of both car insurance and stock insurance, accidents can happen for micro and macro reasons. On the micro front, DWI might pair off with accounting irregularities. On the macro side, there’s little way to escape an ice storm.
The variation in the price of “market insurance”, ie, risk premia like vol, makes for a fascinating study. In Oct 2017, a 1m straddle on the $SPX cost 1.5%. In Oct 2008, that same straddle surpassed 20% I’m not so sure Geico would ever need to update its models to that degree!
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