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Can we forecast the implied volatility surface dynamics of equity options? Predictability and economic value tests

Alejandro Bernales () and Massimo Guidolin ()

Journal of Banking & Finance, 2014, vol. 46, issue C, 326-342

Abstract: We examine whether the dynamics of the implied volatility surface of individual equity options contains exploitable predictability patterns. Predictability in implied volatilities is expected due to the learning behavior of agents in option markets. In particular, we explore the possibility that the dynamics of the implied volatility surface of individual stocks may be associated with movements in the volatility surface of S&P 500 index options. We present evidence of strong predictable features in the cross-section of equity options and of dynamic linkages between the volatility surfaces of equity and S&P 500 index options. Moreover, time-variation in stock option volatility surfaces is best predicted by incorporating information from the dynamics in the surface of S&P 500 options. We analyze the economic value of such dynamic patterns using strategies that trade straddle and delta-hedged portfolios, and find that before transaction costs such strategies produce abnormal risk-adjusted returns.

Keywords: Equity options; Index options; Implied volatility surface; Predictability; Trading strategies (search for similar items in EconPapers)
JEL-codes: C53 G13 G17 (search for similar items in EconPapers)
Date: 2014
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Working Paper: Can We Forecast the Implied Volatility Surface Dynamics of Equity Options? Predictability and Economic Value Tests (2012) Downloads
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Handle: RePEc:eee:jbfina:v:46:y:2014:i:c:p:326-342