From the November 01, 2011 issue of Futures Magazine • Subscribe!

Stock market trends and the volatility premium

The implied volatility of a stock index is one of the key descriptive variables of the market’s behavior. Its importance often is underestimated despite its huge impact on the price of the option and, thereby, the profit or loss on a trade.

Studies have analyzed how the volatility implied by option prices relates to the subsequent realized volatility (see "Implied to realized," below). Despite all the statistical problems such as overlapping time intervals, bid/ask spreads of the options, etc., experts usually agree that a volatility premium exists: The implied often is higher than the corresponding realized volatility.

So-called "vola short" strategies enjoyed a great deal of popularity before the financial crisis of 2008-09. Because of significant losses of those strategies during the financial crisis, however, many funds using those strategies were wiped out completely. Constantly shorting volatility can earn a premium but has huge risks in a downturn when realized volatility increases sharply. Similar losses of pure vola short strategies have been seen recently as the European debt crisis has led to higher stock market volatilities.

Some proponents argue that it should be profitable to short implied volatility when it is high because the premium earned for selling options is higher in these situations. However, this approach, as we have seen, has certain risks that must be controlled. So, when should stock investors buy and when should they write options? A closer look at equity market behavior in the last years sheds some light on this question.

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