Predicting Volatility Risk Premium Through Sector Implied Correlation

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The volatility risk premium is a common phenomenon that exists in the volatility space. It is often defined as a stock’s or index’s implied volatility (IV) minus its realized volatility (RV). For equity indices, over the long term IV is generally greater than RV, thus giving rise to the popularity of short volatility trading strategies.

Despite its frequent use, it appears, however, that there exists no reliable method for forecasting the volatility risk premium. In the literature, we have seen methods ranging from a simple one such as IV-HV (historical volatility) to a more sophisticated method such as GARCH.

A recent article [1] examines the volatility risk premium through implied volatilities and the correlation of sector ETFs. It concludes, surprisingly, that correlation premium is a good predictor of the volatility risk premium,

We posit that abnormalities in the short-term pricing of an index option can be better detected by studying the implied correlation than the implied volatility. A high index volatility premium may be attributed to rationally-expected high stock implied volatilities. In this case, the correlation premium, defined analogously to the volatility premium as current implied correlation less recent realized correlation, would not necessarily be high because implied correlation is calculated using stock implied volatilities as inputs and therefore controls for their levels. On the other hand, an abnormally high correlation premium can signal either rationally-expected high correlations or some temporary deviation in the index implied volatility. We demonstrate that it is often the latter and that a measure of abnormal correlation premium is more predictive of future changes in sector implied volatility than is the volatility premium. Building on this finding, we also show that trading signals concerning sector option implied volatilities based on the abnormal correlation premium are profitable in absolute terms, and also more profitable than conventional strategies based on the volatility premium

Using the abnormal correlation premium to generate signals, the authors manage to develop profitable options trading strategies. These strategies are delta- and vega-neutral.

References

[1] Koticha, Apoorva and Li, Chen and Marks, Joseph M., Abnormal Sector Option Correlation Premiums and Predictable Changes in Implied Volatility (2021). https://ssrn.com/abstract=3862777

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