The strategy trades SPY options by exploiting price differences between breakeven and market values using a calibrated volatility model, delta-hedging positions, and targeting significant price deviations for profits.
ASSET CLASS: ETFs, options | REGION: United States | FREQUENCY:
Daily | MARKET: equities | KEYWORD: Volatility Arbitrage, Breakeven
I. STRATEGY IN A NUTSHELL
Trade SPY options and ETFs using breakeven volatility to identify mispriced options. Delta-hedged positions are taken when market prices diverge from fair prices, held until five days before expiration. Model calibrated annually using SpiderRock and Bloomberg data.
II. ECONOMIC RATIONALE
Mispricing arises when market-implied volatility deviates from breakeven volatility. The strategy profits by shorting overpriced options or buying underpriced ones, leveraging a robust nonparametric model that adjusts for real-world market dynamics.
III. SOURCE PAPER
Option Pricing Via Breakeven Volatility [Click to Open PDF]
Blair Hull, HTAA, LLC; Anlong Li, Hull Tactical Funds; Xiao Qiao, City University of Hong Kong (CityU)
<Abstract>
The fair value of an option is given by breakeven volatility, the value of implied volatility that sets the profit-and-loss of a delta-hedged option to zero. We calculate breakeven volatility for 400,000 options on the S&P 500 and build a predictive model for these volatilities. A two-stage regression approach captures the majority of observed variation. By providing a link between option characteristics and breakeven volatility, we establish a nonparametric approach of pricing options without the need to specify the underlying price process. We illustrate the economic value of our approach with a simulated trading strategy based on breakeven volatility predictions.
IV. BACKTEST PERFORMANCE
| Annualised Return | 6.68% |
| Volatility | 4.5% |
| Beta | N/A |
| Sharpe Ratio | 1.5 |
| Sortino Ratio | N/A |
| Maximum Drawdown | -3.2% |
| Win Rate | N/A |
