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

See all articles by Peter F. Pope

Peter F. Pope

Bocconi University; London School of Economics and Political Science

Ser-Huang Poon

Alliance Manchester Business School, University of Manchester; Alan Turing Institute

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

Pope, Peter F. and Poon, Ser-Huang, Trading Volatility Spreads: A Test of Index Option Market Efficiency (July, 1999). Lancaster University Management School, Accounting and Finance Working Paper No. 99/12, Available at SSRN: https://ssrn.com/abstract=185968 or http://dx.doi.org/10.2139/ssrn.185968

Peter F. Pope

Bocconi University ( email )

Dept of Accounting
Milan, 20136
Italy

London School of Economics and Political Science ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Ser-Huang Poon (Contact Author)

Alliance Manchester Business School, University of Manchester ( email )

Alliance Manchester Business School
Booth Street West
Manchester, Manchester M15 6PB
United Kingdom
+44 161 275 4031 (Phone)
+44 161 275 4023 (Fax)

HOME PAGE: http://www.manchester.ac.uk/research/Ser-huang.poon/

Alan Turing Institute ( email )

British Library, 96 Euston Road
96 Euston Road
London, NW12DB
United Kingdom

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