Exploiting the Implied Volatility Term Structure
October 26, 2011 - Equity Options, Volatility Effects
An upward (downward) trend in implied volatilities with option maturity indicates that investors expect volatility to increase (decrease) over time. Do such expectations reliably predict future stock options prices? In his October 2011 paper entitled “Volatility Term Structure and the Cross-Section of Option Returns”, Aurelio Vasquez investigates whether the implied volatility term structure (measured as slope of implied volatilities across at-the-money options with receding expiration dates) predicts future option returns. Specifically, each month he ranks stocks into deciles by volatility term structure slope and then calculates future returns for extreme deciles from five option trading strategies: (1) naked calls; (2)naked puts; (3) straddles; (4) delta-hedged calls; and, (5) delta-hedged puts. He calculates returns relative to the initial prices of the options traded. Using monthly closing bid and ask prices for at-the-money options (moneyness between 0.95 and 1.05) on a broad sample of U.S. stocks, and associated firm characteristics, during January 1996 through June 2007 (260 stocks per month on average), he finds that: Keep Reading