by Maksym Kosachevskyy
The effectiveness of volatility arbitrage has been a source of debate for researchers. On one hand, some have found the strategy to be immensely profitable, indicating a potential structural mispricing in the options market. Other researchers have claimed these profits arise from hidden risk in the form of higher distribution moments like kurtosis and skewness or that the strategy is highly susceptible to jump risk. In this paper, I examine the risk and return of a set of options volatility arbitrage strategies over the last 6 years to determine the magnitude of a possible mispricing. I construct a portfolio of long straddles using the options in the decile with the greatest positive IV-HV difference and a portfolio of short straddles using the options in the decile with the greatest negative difference. I then calculate the Compound Annual Growth Rate and standard deviation of monthly and weekly strategies, find the optimal Sharpe ratio, and adjust for potential liquidity issues. I find that the combined monthly portfolio can be a strong performer if properly hedged but that only the long portfolio is necessary in the weekly strategy. Both weekly and monthly portfolios can highly effective investments if risk is managed correctly.
Advisors: Professor Jia Li, Professor Kent Kimbrough | JEL Codes: G11, G13, G14
