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The Volatility Risk Premium and De-biased Equity Option Returns

| | Posted in: Equity Options

Should speculators expect a profit from assuming the risk of volatility (for example, by selling options)? In their October 2007 paper entitled “The Price of Market Volatility Risk”, Jefferson Duarte and Christopher Jones employ a combination of simulations and analyses of empirical data to investigate the volatility risk premium. This premium ostensibly provides compensation for those assuming risks stemming from both option contract characteristics and the price variability of the underlying equity. The study addresses biases, induced by large bid-ask spreads, in typical approaches to calculating mean returns for options. Using daily data for options on U.S. equities spanning 1996-2005, they conclude that:

  • There is strong evidence of a volatility risk premium that increases with overall market volatility.
  • Biases related to the relatively large bid-ask spreads of options can produce faulty conclusions about the volatility risk premium and expected option returns. The biases might be large enough, for example, to make out-of-the-money call options on the S&P 500 index appear to have a large, positive mean return, whereas the actual mean return is likely negative (see the table below).

The following table, excerpted from the paper, summarizes mean returns on S&P 500 index options of various times-to-maturity (Short, Medium, Long) and moneyness (In The Money, At The Money, Out of The Money) in basis points per day, adjusted for biases induced by the bid-ask spread. Results suggest that put options are generally unprofitable and that medium time-to-maturity, near-the-money call options are the best long bet. Conversely, selling short-term deep out-of-the-money put options and all maturities of deep out-of-the-money call options is may be quite profitable.

In summary, speculators may be able to exploit the volatility risk premium by selling short-term deep out-of-the-money put options and all maturities of deep out-of-the-money call options on the broad stock market, especially during periods of high volatility.

Hedging/limiting leverage for such short options positions may be desirable to avoid catastrophe when the unexpected happens.

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