Measuring and Trading Volatility on the US Stock Market: A Regime Switching Approach

Serie Documentos de Trabajo - Documento Nro. 659

27 Pages Posted: 23 Oct 2018 Last revised: 12 Dec 2018

Date Written: September 1, 2018

Abstract

The volatility premium is a well-documented phenomenon, which can be approximated by the difference between the previous month level of the VIX Index and the rolling 30-day close-to-close volatility. In concordance with existing literature, we show evidence that VIX is generally above the 30-day rolling volatility giving rise to the volatility premium, so that selling volatility can become a profitable trading strategy as long as proper risk management is under place. As a contribution, we introduce the implementation of a Hidden Markov Model (HMM), identifying two and three states of the nature and showing that the volatility premium undergoes temporal breaks in its behavior. Based on this, we formulate different trading strategies by selling volatility and switching to medium-term U.S. Treasury Bills when appropriated. We test the performance of the strategies using the conventional Carhart four-factor model showing positive and statistically significant alphas, even after considering transaction costs.

Keywords: Realized Volatility, Expected Volatility, Volatility Premium, Regime Switching, Excess Returns, Hidden Markov Model, VIX

JEL Classification: C1, C3, N2, G11

Suggested Citation

Dapena, José Pablo and Serur, Juan Andrés and Siri, Julián Ricardo, Measuring and Trading Volatility on the US Stock Market: A Regime Switching Approach (September 1, 2018). Serie Documentos de Trabajo - Documento Nro. 659. Available at SSRN: https://ssrn.com/abstract=3257073 or http://dx.doi.org/10.2139/ssrn.3257073

José Pablo Dapena (Contact Author)

University of CEMA ( email )

1054 Buenos Aires
Argentina

Juan Andrés Serur

University of CEMA ( email )

No Address Available

Julián Ricardo Siri

University of CEMA ( email )

1054 Buenos Aires
Argentina

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