Category: options trading strategies

October was Favorable for Short Volatility Strategies

Last month was particularly favorable for short volatility strategies. In this post, we will investigate the reasons behind it.

First, the main PnL driver of a delta neutral, short gamma and short vega strategy is the spread between the implied volatility (IV) and the subsequently realized volatility (RV) of returns. Trading strategies such as long butterfly is profitable when, during the life of the position, RV is low compared to IV. The graph below shows the difference between IV and RV for SP500 during the last 5 months. (Note that RV is shifted by 1 month, so that IV-RV presents accurately the spread between the implied volatility and the volatility realized during the following month). As we can see from the graph, IV-RV was high, around 4%-7%, during October (the area around the “10/16” mark). Hence short volatility strategies were generally profitable during October.

implied minus realized volatilities
IV-RV spreads of SP500

The second reason for the profitability is more subtle. The graph below shows the IV-RV spreads in function of monthly returns. As we can see, there is a high degree of correlation between IV-RV and the monthly returns. In fact, we calculated the correlation for the last 10 years and it is 0.69

IV-RV spreads v.s. SP500 monthly returns

This means that when IV-RV is high, SP500 usually trends up. This was the case, for example, during the month after Brexit (see the area around the “07/16” mark on the first graph). However, when the market trends, the cost of hedging in order to keep the position delta neutral is high. By contrast, even though IV-RV was high in October, the market moved in a range, thus helping us to minimize our hedging costs. This factor therefore contributed to the profitability of short volatility strategies.

In summary, October was favorable for short volatility strategies due to the high IV-RV spread and the range bound nature of the market.

The Favorite Long-shot Bias in Option Markets

The favorite long-shot bias is a phenomenon that has been studied extensively in gambling markets. A question has arisen naturally: does this bias exist in financial markets?

In a paper entitled “The Favorite /Long-shot Bias in S&P 500 and FTSE 100 Index Futures Options: The Return to Bets and the Cost of Insurance”, Hodges, Tompkins and Ziemba examined whether the favorite/long-shot bias that has been found in gambling markets (particularly in horse racing markets) applies to options markets. The motivation came from the fact that puts and calls on stock index futures represent leveraged short or long positions on the index and their behavior might have similar features to racetrack bets.

The authors found that both call and put options on the S&P 500 (and FTSE 100 to some degree) with one and three months to expiration display a relationship between probabilities of finishing in the money and expected returns that is very similar to the favorite long-shot bias in horse racing markets. In another word, they found evidence that was consistent with the hypothesis that investors tend to overpay for put options as the expected cost of insurance and call options as low-cost, high-payoff gambles.

This finding is consistent with results published by other researchers under the general framework of the volatility risk premium which refers to the fact that implied volatility in equity index options often tends to overstate realized volatility. In fact, the favorite/long-shot bias provides an alternative explanation for the existence of volatility risk premium.

For practitioners, a question arose: how to structure a position that takes advantage of the favorite long-shot bias?