Highly Evolved Vol

The variance premium in developed equity markets is a well established phenomenon. It persists . Anyone with an equity portfolio should take advantage of it . And you really should be trading options to do so. But even after accepting this, you still need to decide which particular options to sell. SPY alone has thousands to choose from. Two recent papers help with this decision. The first is, " Understanding and Trading the Term Structure of Volatility" , by Campasano and Linn. They look at the dynamics of implied volatility, and show it depends both on the slope of the term structure and also the maturity of the options. It is the maturity aspect that is relevant to us. They find that the returns to short one month straddles is about three and a half times that of short six month straddles. The other relevant paper is, "Which Index Options Should You Sell" , by Israelov and Tummala of AQR. They look at returns for a given unit of risk. The most interest

The VIX is obviously very low. But, as I've written , it can stay long for a very long time. Generally, a specific catalyst is required for it to rise. It never hurts to guess what such a catalyst might be. A reader recently suggested to me that the current Fed tightening phase might be such a catalyst. It is hard to know if this is true. Looking at the last case is probably the only hint we have. Below I show the Fed funds rate and the VIX from 2004 to the end of 2006, which was the last time the Fed was raising rates. Again, not much can be concluded from one instance, but the relationship was obviously negative. The VIX dropped as rates were raised. The Fed was very careful to telegraph their intent and not spook markets. I can't see why this time would be different.