The Profitability of Volatility Spread Trading on European Equity Options

Abstract

Volatility is mean-reverting by nature. A large divergence between option implied volatility and long-run historical volatility is a potential signal of option mispricing. Goyal and Saretto (2009) propose an option trading strategy relying on this signal. Their findings are later verified by Do, Foster and Gray (2016) who on the other hand question the authenticity of the returns due to transaction costs. The purpose of this study is to verify the U.S. and Australian findings in the European setting examining options on the most liquid stocks in the European market. Transaction costs in the form of bid-ask spreads are lower for liquid options.

This thesis employs data on European equity options during 2014–2018. The options’ underlying stocks are required to be a member of the EURO STOXX 50 Index to ensure liquidity. The final sample consist of 1 794 matched pairs of call and put options that are at-the-money and have one month to maturity. Each month the options are sorted into tertile, quintile and sign difference portfolios by the volatility spread. Within each portfolio, option straddles of the call-put pairs are established, and the cross-sectional returns are calculated. A panel regression is run to examine the reasons for the volatility spread. Also, the straddle returns are regressed on explanatory variables to examine whether they are attributed to the volatility spread.

The results of this study show that a negative spread between the historical volatility and the implied volatility indicates overpricing of an option. By shorting straddles on overpriced options, statistically significant returns are attainable. Depending on the way the options are sorted, the average monthly returns vary from 4.96% to 9.26%. The reason for the volatility spread is that traders may overemphasize the recent behavior of the underlying stock. Despite the promising returns from the short straddles, the returns are not significantly related to the spread. The reason for it is likely explained by the composition of the sample that includes a period in which the volatility spreads are unevenly distributed, making the sorting of the options difficult.