In this research paper, “Measuring and Trading Volatility on the US Stock Market: A Regime Switching Approach,” authored by José P Dapena, Juan A. Serur, and Julián Ricardo Siri, the exploration delves into the intricacies of the volatility premium—a well-documented phenomenon in financial markets. The volatility premium is approximated as the difference between the previous month’s level of the VIX Index and the rolling 30-day close-to-close volatility.
Aligned with existing literature, the paper provides evidence that the VIX consistently surpasses the 30-day rolling volatility, thereby creating the volatility premium. This observation suggests that selling volatility can be a profitable trading strategy, contingent upon the implementation of effective risk management practices.
As a significant contribution to the field, the researchers introduce the implementation of a Hidden Markov Model (HMM), which identifies two and three states of market nature. This modeling approach reveals that the volatility premium undergoes temporal breaks in its behavior.
Building upon these insights, the paper formulates distinct trading strategies that involve selling volatility and strategically switching to medium-term U.S. Treasury Bills when deemed appropriate based on the identified market states.
The performance of these strategies is rigorously tested using the conventional Carhart four-factor model, demonstrating positive and statistically significant alphas even after accounting for transaction costs.
The research thus offers valuable contributions to understanding volatility dynamics, providing practitioners with insights into the potential profitability of trading strategies in the context of changing market regimes.
Abstract Of Paper
The volatility premium is a well-documented phenomenon, which can be approximated by the difference between the previous month level of the VIX Index and the rolling 30-day close-to-close volatility. In concordance with existing literature, we show evidence that VIX is generally above the 30-day rolling volatility giving rise to the volatility premium, so that selling volatility can become a profitable trading strategy as long as proper risk management is under place. As a contribution, we introduce the implementation of a Hidden Markov Model (HMM), identifying two and three states of the nature and showing that the volatility premium undergoes temporal breaks in its behavior. Based on this, we formulate different trading strategies by selling volatility and switching to medium-term U.S. Treasury Bills when appropriated. We test the performance of the strategies using the conventional Carhart four-factor model showing positive and statistically significant alphas, even after considering transaction costs.
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Author
José P Dapena
University of CEMA
Juan A. Serur
NYU – Courant Institute of Mathematical Sciences
Julián Ricardo Siri
University of CEMA
Conclusion
In this exploration led by José P Dapena, Juan A. Serur, and Julián Ricardo Siri, the focus is on measuring and trading volatility on the US stock market through a novel Regime Switching Approach.
The well-documented phenomenon of the volatility premium, approximated by the VIX Index’s difference from the rolling 30-day close-to-close volatility, is confirmed. Consistent with existing literature, the study establishes that the VIX tends to be above the 30-day rolling volatility, creating a profitable opportunity for those engaged in selling volatility, contingent upon effective risk management.
A notable contribution to the field is the introduction of a Hidden Markov Model (HMM), revealing two and three states of nature and highlighting temporal breaks in the behavior of the volatility premium. Building on this insight, various trading strategies are formulated, involving selling volatility and transitioning to medium-term U.S. Treasury Bills when deemed appropriate.
The performance of these strategies is rigorously tested using the conventional Carhart four-factor model, demonstrating positive and statistically significant alphas even after factoring in transaction costs.
In summary, this research illuminates the dynamics of the volatility premium and introduces a Regime Switching Approach, offering a nuanced understanding of temporal breaks in its behavior.
The trading strategies outlined, supported by the Hidden Markov Model, present a compelling avenue for capitalizing on the volatility premium, with implications for practitioners seeking to navigate and exploit volatility dynamics in the US stock market.
FAQ:
– What is the main focus of the research paper “Measuring and Trading Volatility on the US Stock Market: A Regime Switching Approach” by José P. Dapena, Juan A. Serur, and Julián Ricardo Siri?
The research paper examines the concept of the volatility premium in the US stock market and introduces a novel regime-switching approach for measuring and implementing trading strategies, particularly those involving selling volatility.
– What is the key finding of the study regarding the volatility premium, and how does it impact trading strategies?
The study provides evidence that the VIX Index consistently exceeds the 30-day rolling volatility, creating conditions favorable for the volatility premium. This finding suggests that trading strategies involving selling volatility can be profitable, provided that effective risk management is in place.
– What is the significant contribution of the authors, and how do they formulate and test trading strategies?
The authors introduce a Hidden Markov Model (HMM) to the analysis, revealing two and three states of market behavior and temporal breaks in the behavior of the volatility premium. Building on this insight, they formulate trading strategies that involve selling volatility and transitioning to medium-term US Treasury Bills when appropriate. These strategies are rigorously tested using the conventional Carhart four-factor model, which demonstrates positive and statistically significant alphas, even after accounting for transaction costs.
