Volatility selling (on equity indices)
â¢ Selling volatility using equity index options is the purest example of selling lottery tickets that pay off (to the buyer) in bad times. Such strategies deserve high risk premia because large losses (spiking volatility) tend to coincide with market crashes. Understanding this strategy is important even if one does not trade it. Many investors do trade related strategies, such as carry.
â¢ The strategyâs high SR over 20 years between the 1987 and 2008 crashes also reflects a peso problemâthe absence of that rare large-loss event from the sample. A proximate reason for the strategyâs long-run success is the persistent pattern that implied volatilities of index options tend to exceed realized volatilities by 2% to 4%.
â¢ For single-stock options, the average gap between implied and realized volatilities is nearer to zero. This contrast is suggestive of a correlation risk premium rather than a variance (volatility) risk premium. Correlation tradingâselling volatility on an equity index and buying volatility on its single-stock constituentsâhas been historically profitable but loses money when realized correlations spike up.
â¢ In addition, covered-call-writing strategies, which are in the category of volatility selling strategies, have been profitable in the past but their performance partly reflects long equity market exposure and not just volatility risk exposure.
â¢ The theoretical sign of skewness preferences can be debated ...