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Cross-Section of Option Returns and Volatility

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What they found

The authors sorted individual stock options by the gap between their historical realized volatility and their current implied volatility. Options on stocks where implied volatility was far above the historical level were overpriced, and those where it was far below were underpriced: a portfolio that bought straddles on the low-IV-relative-to-HV stocks and sold straddles on the high-IV-relative-to-HV stocks earned economically large returns from 1996 to 2006. They interpret this as volatility mean reversion that option prices do not fully incorporate.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

The volatility smile across strikesImplied volatility plotted against strike, dipping near the money and turning up at both ends, more steeply on the downside.Implied volatility32%28%24%20%8090110120Puts below the money cost moreFar calls cost more tooLowest IV near the moneyATM 100Strike price
The volatility smile. Options on the same stock and the same expiry are not priced off one volatility. Strikes near the money carry the lowest implied volatility, and it rises towards both ends — usually faster on the downside, which tilts the smile into a skew.

What you can use

  • When a stock's implied volatility is unusually high relative to its own history, its options are more often overpriced than correctly priced.
  • Implied volatility overreacts to recent volatility shocks and mean-reverts; this is a systematic source of option mispricing.
  • Comparing IV to realized volatility over a long lookback is a simple, research-backed way to rank option richness.

Caveats

Long-short straddle portfolios with high turnover; the authors show profits survive reasonable costs but not extreme bid-ask spreads on illiquid options. Post-publication returns are lower.

Tags: options, option-returns, implied-volatility, volatility-mean-reversion

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.