Tendency of investors to need downside protection

CFA Level III Portfolio Management
#1

“One behavioral theory set out by Shefrin (2008) recognizes the tendency of investors to need downside protection to avoid negatively skewed returns. This investor preference displays excessive risk relative to likely outcomes. Securities that embody significant downside risks in an adverse economic environment, therefore, reflect this risk aversion and offer a premium. An optimal portfolio, taking advantage of behavioral biases, would recognize the extent to which stocks reflect this risk aversion premium, and thus offer returns in excess of true risk. Writing (selling) out-of-the-money put options on securities or indexes would be one way to reflect this risk.”

Could someone explain this paragraph- specifically what the author is trying to get across? I’m confused as to what the author’s point is- that selling OOTM puts is a type of correctable bias? Or a way to take advantage of a bias to generate alpha?

#2

If investors exhibit high risk aversion, they protect downside of long underlying with long Puts (Protective Put strategy).

This drives up the price of Puts relative to Calls. Hence selling OTM Puts exploits this bias.

#3

Thank you!