Understanding and Trading the Term Structure of Volatility
45 Pages Posted: 17 Nov 2016 Last revised: 8 Feb 2017
Date Written: February 2, 2017
We extensively study the term structure of volatility in individual equity options. We begin by studying the behavior of implied volatility in the cross section. We examine the joint dynamics of short maturity and long maturity implied volatility in order to gain a thorough understanding of how volatility term structure evolves. We uncover a number of stylized facts which, to the best of our knowledge, we are the first to empirically document. We then propose a simple framework of term structure dynamics that captures the features documented in our empirical study. This simple framework is illustrative and gives an intuitive way to understand the dynamics of the volatility term structure seen in the cross section. Using the intuition gleaned from our analysis, we examine strategies for trading volatility. Consistent with the term structure dynamics, we uncover a number of profitable volatility trading strategies across maturities. We further examine the extent to which profitability of these trading strategies is due to an interaction between volatility term structure and realized volatility.
Keywords: Equity Options, Term Structure, Volatility
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