The Risks and Rewards of Selling Volatility
Saikat Nandi and Daniel Waggoner
Economic Review, Vol. 86, No. 1, 2001
The popular practice of selling market volatility through selling straddles exposes traders and investors to substantial risk, especially in equity markets. The returns can be very lucrative, but the probability of large negative returns far exceeds the probability of large positive returns. In fact, selling straddles has resulted in substantial losses at banks and hedge funds such as the former Barings PLC and Long Term Capital Management.
This article outlines the risks and rewards associated with selling volatility by first examining the statistical properties of the returns generated by selling straddles on the Standard and Poor's 500 index. The authors demonstrate that the usual practice of selling volatility by comparing the observed implied volatility with the volatility expected to prevail could be flawed. This flaw could arise if the underlying asset has a positive risk premium and the returns of the underlying asset are negatively correlated with changes in volatility. Thus, basing the decision to sell a straddle on a comparison of seemingly irrational high implied volatilities with much lower expected volatility could itself be an irrational choice.
Does it help to rebalance the straddle to maintain minimal exposure to market direction? While such rebalancing is theoretically feasible, the authors find that this process exposes the trader to model risk and does not eliminate the skewness of returns from selling volatility.