The Profitability of Volatility Spread Trading on ASX Equity Options

Goyal and Saretto (2009) conjecture that deviations of option implied volatility from long‐run historical levels—the volatility spread—provide a signal of option mispricing. This paper re‐examines the profitability of trading the volatility spread, with a particular focus on assessing the authenticity of returns. While, at face value, portfolios of option straddles designed to exploit this mispricing appear highly profitable, our findings cast doubt over whether these profits can be genuinely attained in real‐world settings. Drawing on the tick history of bid–ask quotes, our analysis suggests that transaction costs erode much of the profitability. Further, we demonstrate that ignoring the existence of initial margins dramatically overstates estimated returns to short option positions. Ultimately, the profitability of volatility spread trading appears to hinge on the ability of traders to achieve effective spreads well inside the quoted spreads and to intelligently time their trades. © 2015 Wiley Periodicals, Inc. Jrl Fut Mark 36:107–126, 2016