On profitability of volatility trading on S&P 500 equity index options: The role of trading frictions

Abstract

This article examines the profitability of volatility trading on S&P 500 equity index options in time-varying market conditions, with a particular focus on evaluating the authenticity of risk-adjusted returns. While significant profits are available on strategies that involve writing put options, our findings cast doubt on whether these profits can be genuinely attained in practice. After bid-ask spreads are included, we find that the profitability is significantly reduced. Furthermore, the implementation of the trades is generally difficult owing to margin requirements as investors have to set aside a large proportion of their wealth into margin accounts and also face a high likelihood of margin calls. Overall, the profitability of volatility trading tends to hinge on the capability of investors to capture the volatility risk premium and to wisely time its trades.