Backtesting the Implied Volatility Long/Short Strategy (12/06/16)

Post Outline

• Strategy Summary
• References
• 4-Week Holding Period Strategy Update
• 1-Week Holding Period Strategy Updated (Target Leverage=2)

Strategy Summary

This is a stylized implementation of the strategy described in the research paper titled "What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns" by Yuhang Xing, Xiaoyan Zhang and Rui Zhao. The authors show that their SKEW factor predicts individual equity returns up to 6 months!

ABSTRACT

Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 10.9% per year on a risk-adjusted basis.This predictability persists for at least six months

Here is the skew measure they use.

SOURCE: WHAT DOES INDIVIDUAL OPTION VOLATILITY SMIRK TELL US ABOUT FUTURE EQUITY RETURNS?

My strategy differs in that I arbitrarily chose 1 and 4 week holding periods to study. Additionally this strategy only analyzes a cross-section of ETFs instead of individual stocks. I chose ETFs because liquidity and data quality concerns are minimized. Here are the selected ETFs under analysis.

References:

1. Zhang, Xiaoyan and Zhao, Rui and Xing, Yuhang, What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns? (August 14, 2008). AFA 2009 San Francisco Meetings Paper. Available at SSRN:http://ssrn.com/abstract=1107464 orhttp://dx.doi.org/10.2139/ssrn.1107464

4-Week Holding Period Strategy Update

*Results simulated using the Quantopian Platform.

Download the spreadsheet here.

Download a text file of all the portfolio stocks here.

1-Week Holding Period Strategy Update (Target Leverage=2)

RESULTS SIMULATED USING QUANTOPIAN PLATFORM