Volatility Risk Premium and the Risks of Selling Options
Summary
The document explains why equity index options may carry a volatility risk premium: investors value protection against sharp losses and may pay more for options than subsequent realized volatility justifies. It describes a monthly strategy that sells a one-month at-the-money straddle, buys far out-of-the-money puts as crash insurance, and invests the remaining cash in the index. The cited research discusses option returns, downside risk compensation, and possible links between the premium and market volatility.
The strategy is exposed to severe, clustered losses during market crises, so margin reserves can materially reduce returns. The document warns that short volatility is not a dependable equity hedge. It also notes that option return estimates can be affected by measurement error, trading costs, margin assumptions, and hedging frequency; results from historical samples do not establish future performance.
Key ideas
- Equity index options have often implied more volatility than was later realized, which may compensate investors who sell options.
- The proposed monthly portfolio sells at-the-money straddles and buys distant out-of-the-money puts for crash protection.
- Short volatility strategies can suffer extreme losses, especially when negative returns cluster during crises.
- Margin reserves and implementation costs can reduce the apparent returns of option-selling strategies.
- Research attributes the premium partly to demand for portfolio insurance, while rare-event explanations remain debated.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.