Can We Forecast the Implied Volatility Surface Dynamics of Equity Options? Predictability and Economic Value Tests

40 Pages Posted: 7 Nov 2013

See all articles by Alejandro Bernales

Alejandro Bernales

Universidad de Chile

Massimo Guidolin

Bocconi University - Department of Finance

Date Written: November 7, 2013

Abstract

We examine whether the dynamics of the implied volatility surface of individual equity options contains exploitable predictability patterns. Predictability in implied volatilities is expected due to the learning behavior of agents in option markets. In particular, we explore the possibility that the dynamics of the implied volatility surface of individual equity options may be associated with movements in the volatility surface of S&P 500 index options. We present evidence of strong predictable features in the cross-section of equity options and of dynamic linkages between the implied volatility surfaces of equity options and S&P 500 index options. Moreover, time-variations in stock option volatility surfaces are best predicted by incorporating information from the dynamics in the implied volatility surface of S&P 500 index options. We analyze the economic value of such dynamic patterns using strategies that trade straddle and delta-hedged portfolios, and we find that before transaction costs such strategies produce abnormal risk-adjusted returns.

Keywords: Equity options, Index options, Implied volatility surface, Predictability, Trading strategies

JEL Classification: C53, G13, G17

Suggested Citation

Bernales, Alejandro and Guidolin, Massimo, Can We Forecast the Implied Volatility Surface Dynamics of Equity Options? Predictability and Economic Value Tests (November 7, 2013). Available at SSRN: https://ssrn.com/abstract=2351203 or http://dx.doi.org/10.2139/ssrn.2351203

Alejandro Bernales (Contact Author)

Universidad de Chile ( email )

Diagonal Paraguay 257
Santiago
Chile

HOME PAGE: http://www.alejandrobernales.com

Massimo Guidolin

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

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