NN IP: Trading volatility - How we benefit from changing market conditions
NN IP: Trading volatility - How we benefit from changing market conditions
Investors can insure their financial portfolios by buying derivative products such as options. An option price is usually quoted in terms of implied volatility, which can be understood as the amount of future market volatility that would justify the option price. Historically, implied volatility was often higher than the subsequently realized volatility. This volatility related premium compensates the seller for the associated tail risk.
However, constantly changing market environments mean that the premiums paid for options also change with time. Therefore, situations can occur where selling options is not attractive and a long option position could even provide cheap insurance against outsized market moves.
In this paper we consider the traditional factors momentum, value and carry, and explore whether factor-based strategies can benefit from changing volatility premiums in the VIX, a major volatility index that aggregates option prices on the S&P 500 index.
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