For traders looking to exploit the opportunities offered by the financial markets, understanding the volatility premium is essential. In this article, we will define the Volatility Premium, examine its implications in algo trading, and explore how it can be used to optimize trading strategies.
What is Volatility Premium?
Volatility premium refers to the difference between implied volatility (option price) and realized volatility (option value). In simple terms, it is the remuneration option sellers receive for assuming the risk of sudden variations in market volatility.
Although the volatility premium is commonly associated with stock markets, it can also be observed in other asset classes, such as commodities or currencies. This universality reinforces the importance of the volatility premium for traders of all backgrounds.
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Why is the Volatility Premium important in algo trading?
The importance of the volatility premium lies in the fact that the implied volatility of options is, on average, higher than the subsequent realized volatility. This means that traders can potentially make systematic profits by selling short-term options.
The cause of Volatility Premium
Several theories attempt to explain the existence of the volatility premium. Some researchers suggest that this premium is due to investors who strongly dislike negative returns and high volatility on stock market indices. These investors would therefore be willing to pay a premium for the portfolio insurance offered by puts.
Others put forward the Peso Problem hypothesis, where a rare but influential event could reasonably have occurred (and suppressed the premium) but did not in the sample. However, this explanation seems unlikely, as major crashes would have to occur every few years to completely eliminate the volatility premium.
How to exploit the Volatility Premium in quantitative trading?
Traders can take advantage of the volatility premium by selling short-term options. This strategy can be particularly profitable, with average returns ranging from 0.5% to 1.5% per day. It is essential to note that the volatility premium is attached to each option, with premiums that can exceed 20% or more per year.
Volatility Premium can also be combined with other strategies, such as trend following. Such a combination can offer additional opportunities for diversification and maximizing returns.
The Volatility Premium offers a unique opportunity for quantitative traders to capitalize on the differences between implied and realized volatility. By understanding the nuances of this premium and integrating it into their algo trading strategies, traders can potentially realize significant returns while effectively managing risk.
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