Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Overpricing Volatility


Options selling is better than options buying - but not in a vaccum.


Here's CXO with a look at the general disparity between implied and realized volatility:

Why does the volatility of the stock market as implied by the prices of equity index options generally exceed actual (realized) volatility, thereby indicating large returns for sellers of index options? Is the reward of selling such options commensurate with the risk? In the June 2008 version of his paper entitled "The Volatility Premium", Bjorn Eraker models the volatility risk premium based on the long-run effects of small (normal diffusion) and large (non-normal jumps) shocks to volatility. Using daily returns for the S&P 500 index and daily levels of the CBOE Volatility Index (VIX) over the period 1990-2007, he concludes that:

  • On average, at-the-money S&P 500 index options with one-month maturities imply an index volatility of 19% (based on standard deviation of annualized returns), about 18% more expensive than options priced for a volatility of 16% (close to the observed volatility of 15.7%). This premium varies over time, generally rising and falling with the level of volatility...

  • Empirical evidence confirms that the average returns generated by index option sellers are substantial.

  • The model presented predicts a volatility risk premium roughly in line with empirical observation, driven more by the risk of violent jumps in volatility than the risk of slow drift in volatility. The model predicts high mean returns for shorting out-of-the-money index put options, regardless of volatility level and whether hedged for S&P 500 movement or not. However, variability of returns is also high.

...In summary, modeling suggests that sharp jumps in stock market volatility drive investors to overprice some equity index options, most consistently out-of-the-money put options.

I certainly agree that options generally overprice the the true risk of volatility poppage in the underlying. But I would add that the most consistent overpricing I can remember occurred in the volatility wasteland of 2005-2006, when the VIX was more like in the teens and lower. Realized volatility then was virtually non-existent.

The issue, however, is that these results are incomplete. Any option selling strategy will outperform an option buying strategy more often than not when measured in elapsed time. But it's trickier to quantify the actual profitability. Option shorts gone bad tend to get REALLY bad. And the squeeze is very different. Option buys can only go to zero, and that lack of open end tends to reduce the squeeze. Quite the opposite on options sales.

So yada yada yada, not sure what this study tells us that we don't already know from experience.

But that being said, I do agree with the conclusions. Option selling is a better game than options buying. But not in a vacuum. Sell and go-away can be hazardous to your financial health, it requires tending. And put selling is indeed a good bullish play. If you're looking for a bullish play of course.

< Previous
  • 1
Next >
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Featured Videos