Volatility Risk Premium Is a Reward for Bearing Overnight Risk

The volatility risk premium (VRP) represents the difference between the implied volatility of options and the realized volatility of the underlying asset. Essentially, it reflects the compensation that investors demand for bearing the risk associated with the uncertainty of future volatility. Typically, implied volatility is higher than realized volatility, indicating that options are often overpriced relative to the actual market movements. Understanding and exploiting the VRP can be crucial for designing effective trading strategies and managing risk in financial portfolios.

Reference [1] examines the asymmetry in the VRP. Specifically, it investigates the VRP during the day and overnight sessions. The authors pointed out,

We find a significant difference in the returns from overnight and intraday short option positions, which is not explained by a weekend effect. The return asymmetry declines with increase in option moneyness and maturity. A systematic relationship is found between the day-night option returns and the option Greeks. We extend the results of MN by observing that average postnoon returns are significantly negative (positive) for short positions in call (put) options, while prenoon returns are largely insignificant, suggesting that the VRP changes across the trading day, but differently for calls and puts. We also provide evidence that a significant jump in the underlying index has a dampening effect on the day-night disparity in option returns. We hypothesize that the spike in implied volatilities consequent to a significant jump in the underlying causes an increase in both intraday and overnight option returns, thus reducing their day-night variation. The strong positive and significant overnight returns imply that the VRP embedded in prices of Nifty options is a reward mainly for the overnight risk. Our results show that a strategy of selling index options at the end of the trading day and covering the same at the beginning of the following trading day yields positive returns before accounting for transaction costs, although this strategy is not profitable after factoring in the explicit and implicit transaction costs.

In short, the article concluded that the VRP is negative during the day and positive during the night. It is worth noting that this research was conducted in the Nifty options market, but previous studies in the S&P 500 market reached the same conclusion.

This finding has implications for portfolio managers who use options to manage risks of their portfolios. It helps them to better manage risks.

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References

[1] Aparna Bhat, Piyush Pandey, S. V. D. Nageswara Rao, The asymmetry in day and night option returns: Evidence from an emerging market, J Futures Markets, 2024, 1–18