Challenges of Indexation in S&P 500 Index Volatility Investment Strategies

Abstract

S&P 500 Index option-based volatility indexes have untenable risk-return profiles. These volatility indexes are not designed with consideration of important real-world risk characteristics of options and fail to represent volatility as a differentiated asset-class with relevance to the long-term utility of investors. Implications of the S&P 500 Index return distribution on the profit and loss (P&L) distribution of a directionally hedged option position are presented. The ensuing five cardinal characteristics of options on S&P 500 Index, central to designing viable volatility investment strategies, are enumerated.

Keywords: irreducible risks, asymmetry, fat-tails, term-dependence, strike-dependence, timing, options, volatility, fiduciary, risk-management

JEL Classification: D83, G10, G11, G12, G32