Trading Volatility Spreads: A Test of Index Option Market Efficiency
Lancaster University Management School, Accounting and Finance Working Paper No. 99/12
33 Pages Posted: 21 Oct 1999
Date Written: July, 1999
Abstract
If returns on two assets share common volatility components, the prices of options on the assets should be interdependent and the implied volatility spread should mean revert. We, first demonstrate, using the canonical correlation method, that there is a common component among the volatilities of the returns on S&P 100 and S&P 500 indexes. We then exploit this commonality by trading on the volatility spread between tick-by-tick OEX and SPX call options listed on the CBOE. Our vega-delta-neutral strategies generated significant profits, even after transaction costs are taken into account. The results suggest that the two options markets are not jointly efficient.
JEL Classification: C10, C32, C53, E37, G14
Suggested Citation: Suggested Citation