Originally Posted by RockOn
I haven't looked at option prices for awhile but just did. If I were to buy a 1 year at-the-money put to fully protect a SP500 position it is costing about 8%. That is very expensive insurance (I know the premiums are somewat high right now but not huge). When I last looked at EIA's, some offer unlimited (100%) of the upside, or close to it, for a few percent a year in extra expenses. How do they do it? Is it all gimmicks? (I suspect it is)
It seems to me that they do offer the insurance cheaper than I can do myself in the options market? What am I missing?
I am by no means an expert in these, but when I did investigate them and compared them with DIY approach I found it is hard to replicate them for the individual.
I think the most important thing to understand about annuities are they are very long term investment, and they impose huge surrender fees for the first one to seven years. This also allows the insurance to take long term investments. Typically this means higher rates on their fixed investments and less expensive prices for options.
You are right that a year put is expensive insurance. However, because the price of option increase at the square root of the duration, longer term insurance is cheaper for instance at the money Dec 2010 put cost about 5% per year vs 8% for a 1 year. In theory a 4 year put would cost 4%. I know that Warren Buffett has written decade plus puts for other insurance companies, presumably as hedge for their annuities.
In theory a 10 year put on the S&P should cost 2.5%/year. If you add in the 2+% dividend from the S&P you can see the it hardly cost an insurance company anything offer a product like this.
100% guarrantee to get your money back after 10 years.
100% of the gain of the S&P*
*some restrictions apply ....(caps etc...)
That o insure that in 10 years you will get your money back no matter. But we can also