Empirical Properties of Straddle Returns

Recent studies find that a position in at-the-money (ATM) straddles consistently yields losses. This is interpreted as evidence for the non-redundancy of options and as a risk premium for volatility risk.

Author(s):

Felix Goltz

Head of applied research, EDHEC Risk and Asset Management Research Centre

Wan Ni Lai

IAE, University of Aix Marseille III

This paper analyses this risk premium in more detail by i) assessing the statistical properties of ATM straddle returns, ii) linking these returns to exogenous factors and iii) analysing the role of straddles in a portfolio context. Our findings show that ATM straddle returns seem to follow a random walk and only a small percentage of their variation can be explained by exogenous factors. In addition, when we include the straddle in a portfolio of the underlying asset and a risk-free asset, the resulting optimal portfolio attributes substantial weight to the straddle position. However, the certainty equivalent gains with respect to the presence of a straddle in a portfolio are small and probably do not compensate for transaction costs. We also find that a high rebalancing frequency is crucial for generating significant negative returns and portfolio benefits. Therefore, from an investor's perspective, straddle trading does not seem to be an attractive way to capture the volatility risk premium.

Type: Working paper
Date: le 01/12/2009
Research Cluster : Finance

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