Volatility Spreads and Expected Stock Returns
Turan G. Bali
Georgetown University - Robert Emmett McDonough School of Business
Baruch College - Zicklin School of Business
We examine the relation between expected future volatility (options' implied volatility) and the cross-section of expected returns. A trading strategy buying stocks in the highest implied volatility quintile and shorting stocks in the lowest implied volatility quintile generates insignificant returns. A similar strategy using one-month lagged realized volatility generates significantly negative returns. To investigate the differences and interactions between alternative measures of total risk, we estimate three principal components based on realized volatility, call implied and put implied volatility. Long-short trading strategies generate significant returns only for the second and the third principal components. We find that the second principal component is related to the realized-implied volatility spread which can be viewed as a proxy for volatility risk. We find that the third principal component is related to the call-put implied volatility spread that reflects future price increase of the underlying stock.
Number of Pages in PDF File: 33
Keywords: expected returns, implied volatility, realized volatility, volatility spread
JEL Classification: G12, G13, G14working papers series
Date posted: November 12, 2007
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