Understanding and Trading the Term Structure of Volatility

45 Pages Posted: 17 Nov 2016 Last revised: 8 Feb 2017

See all articles by Jim Campasano

Jim Campasano

Kansas State University - Department of Finance

Matthew Linn

Isenberg School of Management, University of Massachusetts

Date Written: February 2, 2017

Abstract

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

Suggested Citation

Campasano, Jim and Linn, Matthew, Understanding and Trading the Term Structure of Volatility (February 2, 2017). Available at SSRN: https://ssrn.com/abstract=2871616 or http://dx.doi.org/10.2139/ssrn.2871616

Jim Campasano (Contact Author)

Kansas State University - Department of Finance ( email )

Manhattan, KS 66506
United States

Matthew Linn

Isenberg School of Management, University of Massachusetts ( email )

Amherst, MA 01003
United States

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