Why Does Volatility Uncertainty Predict Equity Option Returns?

61 Pages Posted: 25 May 2018 Last revised: 17 Mar 2022

See all articles by Jie Cao

Jie Cao

The Hong Kong Polytechnic University - School of Accounting and Finance

Aurelio Vasquez

Instituto Tecnológico Autónomo de México (ITAM) - Department of Business Administration

Xiao Xiao

University of Amsterdam - Amsterdam Business School

Xintong Zhan

Department of Finance, School of Management, Fudan University

Date Written: March 10, 2022

Abstract

Delta-hedged option returns consistently decrease in volatility of volatility changes (volatility uncertainty), for both implied and realized volatilities. We provide a thorough investigation of the underlying mechanisms including model-risk and gambling-preference channels. Uncertainty of both volatilities amplifies the model risk, leading to a higher option premium charged by dealers. Volatility of volatility-increases, rather than that of volatility-decreases, contributes to the effect of implied volatility uncertainty, supporting the gambling-preference channel. We further strengthen this channel by examining the effects of option end-users net demand and lottery-like features, and by decomposing implied volatility changes into systematic and idiosyncratic components.

Keywords: Delta-hedged option returns, volatility uncertainty, volatility-of-volatility, model risk, gambling preference

JEL Classification: G10, G12, C58, D80

Suggested Citation

Cao, Jie and Vasquez, Aurelio and Xiao, Xiao and Zhan, Xintong, Why Does Volatility Uncertainty Predict Equity Option Returns? (March 10, 2022). Available at SSRN: https://ssrn.com/abstract=3178263 or http://dx.doi.org/10.2139/ssrn.3178263

Jie Cao (Contact Author)

The Hong Kong Polytechnic University - School of Accounting and Finance ( email )

Hung Hom, Kowloon
Hong Kong

HOME PAGE: http://sites.google.com/site/jiejaycao

Aurelio Vasquez

Instituto Tecnológico Autónomo de México (ITAM) - Department of Business Administration ( email )

Rio Hondo No. 1
Col. Tizapan-San Angel, 01000
Mexico

Xiao Xiao

University of Amsterdam - Amsterdam Business School ( email )

Spui 21
Amsterdam, 1018 WB
Netherlands

Xintong Zhan

Department of Finance, School of Management, Fudan University ( email )

No. 670, Guoshun Road
No.670 Guoshun Road
Shanghai, 200433
China

HOME PAGE: http://sites.google.com/view/xintongzhan

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