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The risks and rewards of selling volatility

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Author Info

  • Saikat Nandi
  • Daniel Waggoner

Abstract

The popular practice of selling market volatility through selling straddles exposes traders and investors to substantial risk, especially in equity markets. The returns can be very lucrative, but the probability of large negative returns far exceeds the probability of large positive returns. In fact, selling straddles has resulted in substantial losses at banks and hedge funds such as the former Barings PLC and Long Term Capital Management. ; This article outlines the risks and rewards associated with selling volatility by first examining the statistical properties of the returns generated by selling straddles on the Standard and Poor's 500 index. The authors demonstrate that the usual practice of selling volatility by comparing the observed implied volatility with the volatility expected to prevail could be flawed. This flaw could arise if the underlying asset has a positive risk premium and the returns of the underlying asset are negatively correlated with changes in volatility. Thus, basing the decision to sell a straddle on a comparison of seemingly irrational high implied volatilities with much lower expected volatility could itself be an irrational choice. ; Does it help to rebalance the straddle to maintain minimal exposure to market direction? While such rebalancing is theoretically feasible, the authors find that this process exposes the trader to model risk and does not eliminate the skewness of returns from selling volatility.

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Bibliographic Info

Article provided by Federal Reserve Bank of Atlanta in its journal Economic Review.

Volume (Year): (2001)
Issue (Month): Q1 ()
Pages: 31-39

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Handle: RePEc:fip:fedaer:y:2001:i:q1:p:31-39:n:v.86no.1

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Related research

Keywords: Stock market ; Asset pricing ; Risk management;

References

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  1. Saikat Nandi & Daniel F. Waggoner, 2000. "Issues in hedging options positions," Economic Review, Federal Reserve Bank of Atlanta, issue Q1, pages 24-39.
  2. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
  3. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  4. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
  5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  6. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
  7. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
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