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

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