Sector Option Correlation Premiums and Predictable Changes in Implied Volatility

Abstract

We examine options listed on sector ETFs that constitute the S&P 500 and find evidence of predictability in implied volatilities associated with abnormally high or low implied correlations. We show that sector-implied volatilities evolve to maintain stable relations between sector correlation premiums and the correlation premium on the S&P 500, allowing the calculation of a sector-specific, idiosyncratic correlation premium. The sector-specific correlation premium is a more reliable signal of future changes in sector-implied volatility relative to simple level measures of the volatility or correlation premiums due to its focus on correlation rather than volatility, and its adjustment for aggregate levels. Moreover, we find that one-day reversals in sector-implied volatilities are related only to reversals in the sector-specific correlation premium, and that information extracted from stock-implied volatilities has little or no predictive ability for sector-implied volatility. The predictable variation in sector-implied volatilities associated with the sector-specific component of the correlation premium forms the basis for profitable trading signals that dominate strategies based directly on sector volatility premiums.