Theoretical and empirical analysis of volatility selling strategies

Abstract

Investing in the nancial markets bears various types of risks. One of the common risks that most practitioners always seek to hedge against is the risk of abrupt shifts in the price of an asset. One generic tool serving that purpose is options. For instance, holding on to an asset exposes one's portfolio to the downside risk to hedge against which one can buy a put option. Similarly, a call option can protect against dramatic rises in the price of an asset. Returns delivered by options became a central point of a number of researches in the past decades. The commencement of this theory is closely tied to the central work of this topic by Black and Scholes (1973). There are notable properties in the relationship between risks and return of options. They became interesting for many researches, including Scholes et al. (1982) and Merton et al. (1978) who propose investment strategies using options, Jackwerth (2000) who suggests mispricing of options in the market, and Coval and Shumway (2001) who show a thorough overview on characteristics of call, put and straddle returns. Many previous studies show striking features of options. For instance, there is a persistent gap between realized volatility and implied volatility for most indexes, including equities and other asset classes like commodities. However, the gap is usually near zero for individual stocks. Another remarkable observation pointed out by many researchers is that mean return of holding put options on equity index until maturity leads to average negative returns (e.g. Coval and Shumway (2001), Jackwerth (2000), Broadie et al. (2007)). However, the average return of a long call option is, on average, positive (e.g. Coval and Shumway (2001), Wilkens (2007)). Those noteworthy observations indicate, as many researchers suggest, a connection between several types of risk premia and option-related trading strategies. For instance, Bakshi and Kapadia (2003) identify the volatility risk premium in delta-hedged options. They showed that delta-hedging decreases exposure to the market, while the volatility risk premium signi cantly a ects that strategy, especially, in times of crises. Driessen et al. (2006) and Buraschi et al. (2013) point out correlation premium in the strategy of selling index options and buying options on its constituents that delivers positive returns, on average. Boyer and Vorkink (2014) show sign of skewness preferences in lottery-like options (out-of-the-money calls on single-stock options). Our thesis focuses on volatility risk premium and the returns of selling volatility strategies using an equity index (selling options, selling statically delta-hedged options and selling dynamically delta-hedged options). In this study, we summarize the theoretical background behind the nature of aforementioned strategies, that is missing in most papers related to this topic, propose expectations directly following from them and provide empirical assessment of the latter. Thus, our work contributes to the ever-growing eld of studies dedicated to understanding the drivers behind the returns of the volatility selling strategies.