The Risks and Rewards of Selling Volatility
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چکیده
prevail until the options expire. It is possible to form a portfolio of call and put options so that the portfo-lio's payoff is very sensitive to the volatility of the underlying asset but only minimally sensitive to changes in the level of the underlying asset. Traders and investors who frequently buy or sell such portfolios do so with a view of the volatility of the underlying asset that does not correspond to the expected future volatility embedded in the option price, or the implied volatility. 1 For example, the former hedge fund Long Term Capital Management had created portfolios of options on certain stock indexes based on its view that expected future volatility was different from the prevailing implied volatilities (Dunbar 1999). There is often substantial risk, however, in options portfolios set up to exploit a perceived mis-pricing in the expected volatility of the underlying asset without initial sensitivity to the level of the asset. This risk stems from possible subsequent abrupt changes in the level of the asset price. Changes in volatilities are highly negatively correlated with changes in levels in many asset markets. If a short position in implied volatility on a market is created and a subsequent sharp market decline results in much higher implied volatility, the value of the implicit short position in volatility could dramatically decrease. For example, the former Barings PLC sustained huge losses from short positions in volatility (initiated by a trader, Nick Leeson) on Nikkei futures as the Nikkei plunged in early 1995 (Jorion 2000). The objective of this article is to delineate the risks and rewards associated with the popular practice of selling volatility through selling a particular portfolio of options called straddles. Toward this end, the article first examines the statistical properties of the returns generated by selling straddles on the Standard and Poor's (S&P) 500 index. Although it is theoretically possible to construct other options portfolios to make volatility bets (Carr and Madan 1998), straddles are by far the most popular type of portfolio. The article also demonstrates that the usual practice of selling volatility by comparing the observed implied volatility (from option prices) with the volatility expected to prevail (given the history of asset prices) could be flawed. This flaw could arise if the underlying asset has a positive risk premium—that is, if its expected return over a given horizon exceeds the risk-free rate over the Nandi is …
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