JPM How Close To Realise 2022-11-10 4259949

Global Quantitative &
Derivatives Strategy
10 November 2022
How close to realised should

implied vol trade?
Revisiting P&L attribution for vanilla SPX options
 It is commonly accepted that the P&L of a delta hedged option primarily Global Quantitative and
depends on the volatility premium, i.e., the difference between implied and Derivatives Strategy
realized volatility. Olivier Daviaud, PhD, CFA AC
(33-1) 4015 4133
 However, the theory that underpins this notion comes with some caveats, and it olivier.daviaud@jpmorgan.com
is not difficult to find real life counterexamples. J.P. Morgan Securities plc
Dobromir Tzotchev, PhD

 In this piece we apply a recently developed technique to delta-hedged SPX
(44-20) 7134-5331
options, and calculate the fraction of P&L which comes from the volatility dobromir.tzotchev@jpmorgan.com
premium. J.P. Morgan Securities plc
 We find that, on average over the past 15 years and for at-the-money options Bram Kaplan, CFA
(1-212) 272-1215
held to maturity and delta hedged daily, the volatility premium was not the
bram.kaplan@jpmorgan.com
main driver of cumulative performance. Instead, the main contributor was
J.P. Morgan Securities LLC
the gamma covariance effect, a quantity linked to the correlation between
gamma and realized volatility. The volatility premium, however, was
responsible for most of the volatility, and, for medium- to long-term options,
was the main performance driver during periods of relative market stability.
 These findings bring some nuance to the notion that implied volatility, or ex-
ante views on the difference between implied and realized volatility, should be
the primary guide to investment decisions in the options space.
 As a first step toward assessing the ex-ante contribution of that second P&L
driver, we derive an approximate formula for its expected value and present it in
the Appendix.
2.5
Average terminal P&L in $ for $1 Vega sold at inception
1.5
0.5
-0.5
-1
1w 1m 3m 12m
VolPremiumTerm gammaCovarianceTerm dGammaTerm residualDriftTerm Actual PnL vs decomposition VolPremium Actual PnL
Source: J.P. Morgan Quantitative and Derivatives Strategy
See page 31 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the
firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in
making their investment decision.
www.jpmorganmarkets.com
This document is being provided for the exclusive use of ADITYA GARG at JPMorgan Chase & Co. and clients of J.P. Morgan.
Olivier Daviaud, PhD, CFA Global Quantitative & Derivatives Strategy
(33-1) 4015 4133 10 November 2022
olivier.daviaud@jpmorgan.com
Table of Contents
Implied volatility trades around realized. Why?.....................3
What is the P&L of a delta hedged option?............................4
Applying that formula to SPX options ....................................6
Zooming in on the volatility premium component.................8
The elephant in the room: the gamma covariance effect....10
What about out of the money options? ................................15
A first foray into relative value ..............................................18
Appendix .................................................................................21
References ..............................................................................30
(33-1) 4015 4133 10 November 2022
Implied volatility trades around realized.

Why?
At-the-money volatility tends to trade near realized. This market pattern finds its
roots in the Black Scholes equation, which implies that over a short time interval the
P&L of a delta hedged option is proportional to implied minus realized volatility. If
implied rises above realized, investors can sell a delta hedged option to generate a
profit. This flow, in turn, puts downward pressure on implied vol, causing it to drop
back towards realized.
To a large extent, this is the heuristic on which options markets are based. But it
contains two important limitations: the first one is that the P&L it describes arises
over a short time interval, and the second is that it implicitly assumes – because it
relies on Black Scholes – that implied volatility is constant. The short time interval
assumption entails that investors’ potential gains are likely to be offset by bid-offer
costs, since the equation’s P&L is proportional to the position’s holding period
whereas bid offer costs aren’t. And the constant implied volatility assumption is at
least as problematic: implied volatility isn’t constant in real life, and its variations
very much feed into the P&L equation of a delta hedged option. So selling a delta
hedged option when implied trades over realized comes with no guarantee of a profit.
To understand where implied volatility should trade, we need a better accounting

tool, or a better trading instrument. Examples of the latter exist. The most canonical
of them is the variance swap, whose payoff is solely a function of realized volatility,
regardless of the path taken by implied volatility throughout the life of the trade. But
the price of a variance swap is a function of the whole implied volatility smile, rather
than of a single strike. Therefore, it does not give us any feedback on the price of a
specific vanilla option. It is conceivable, for example, to have a scenario where at-
the-money volatility is priced wrong while variance swaps are priced fairly.
In Linking the performance of vanilla options to the volatility premium (Risk, 2022),
the authors propose a new accounting tool to tackle this problem, and derive a
generic equation for the P&L of a delta hedged option over an arbitrary time interval.
In particular, that equation provides an explicit link between the option P&L and the
difference between realized volatility and implied volatility at inception, a quantity
known as the volatility premium. Using foreign exchange options, the authors find
that while the volatility premium is the main P&L driver on average, its impact can
be significantly offset (or strengthened) by another component linked to the
correlation between gamma and realized volatility. They find that this effect is
especially pronounced for short-dated options, in that it penalizes the option seller.
In this paper we apply that methodology to SPX options, and find similar
performance patterns. In particular, from the perspective of an option seller the
fraction of the performance which is not linked to the volatility premium is typically
negative for short-dated maturities, and positive for long dated maturities. We also
find it to be more favorable to call sellers than to put sellers, an observation which
makes the case for managing risk reversal trades dynamically rather than holding
them to maturity.
Our piece is structured as follows. We first review the theoretical framework in

(Daviaud & Mukhopadhyay, 2022), and derive a variant of its main result when delta
hedging happens in forward space rather than in spot space. We then apply that
(33-1) 4015 4133 10 November 2022
equation to historical SPX options data, and break down the performance of delta-
hedged options into the various P&L components. In the third and fourth sections,
we analyze the contribution coming from the volatility premium component, and the
contribution coming from the other main P&L driver, the so-called gamma
covariance effect alluded to earlier. Understanding what drives that second
component is key to understanding how far implied volatility can and should deviate
from realized volatility, and we provide, in the appendix, a formula to estimate its
expected value. Finally, we take a first pass at relative value analysis using this new
attribution framework, comparing at-the-money options to out-of-the-money options
and to volatility swaps, respectively.
What is the P&L of a delta hedged option?

In a recently published article, (Daviaud & Mukhopadhyay, 2022) the authors
provide a generic P&L attribution formula for a delta hedged vanilla option. We shall
summarize their approach here, and take that opportunity to adapt their main result to
the case when options are delta hedged using a forward contract rather than spot.
Those of our readers who prefer to skip the math should feel free to jump straight to
the main decomposition on page 5.
Let ( , , σ ) be the price of a vanilla option as a function of time , the forward

price and implied volatility σ. Over a small time interval , the P&L of a vanilla
option delta hedged with the forward contract is equal to
∂
( )−
∂
Expanding the various terms, and assuming implied volatility doesn’t move, this
becomes
∂ ∂ 1∂ ∂
− + + + ⟨ ⟩−
∂ ∂ 2∂ ∂
(1)
Now satisfies the Black-Scholes equation:

∂ 1 ∂
+ − =0
∂ 2 ∂
Moving this back into ( 1 ) and removing the offsetting terms, we get
1∂
P&L = ( ⟨ ⟩− )
2∂
where ⟨ ⟩ denotes the instantaneous realized variance of F. If we relax the

assumption that implied volatility is constant, three extra terms enter the equation:
1∂ ∂ ∂ ∂
P&L = ( ⟨ ⟩− )+ + ⟨ , ⟩+ ⟨ ⟩
2∂ ∂ ∂ ∂ ∂
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This last equation is identical to equation (3) in (Daviaud & Mukhopadhyay, 2022),
which shows that hedging with forward instead of spot has no impact on the
decomposition. From that point on, the calculation details are the same and we can
just replace all mentions of spot by the forward price instead. In particular, a key
insight in (Daviaud & Mukhopadhyay, 2022) is to rewrite the Vega term above using
the equality
∂ ∂
= ( − )
∂ ∂
This leads to a number of cascading effects, one of them being that , in the first
block of the P&L equation above, is replaced by σ , the implied volatility at trade
inception. We won’t reproduce the details here and refer the interested reader to
(Daviaud & Mukhopadhyay, 2022) instead. After rearranging the various blocks and
integrating from inception to an arbitrary time , one gets:
Volatility premium component
Gamma covariance effect
⎡
( ) + (0)
& [ , ] = ⎢⎢ ∗ ( ) − (0) + Cov ∗ (. ), (. )
⎢ 2 2
⎣
Vega term dGamma term
+ ( − )
+ ( )( − )− ( − ) ∗
2 2
Residual drift term
∂ ⎤
+ − ⟨ ⟩⎥
2 ∂ ⎥
⎦
(2)
where
∗
• := is the discounted dollar gamma
• is the implied volatility
• is the instantaneous realised volatility of , and the realised volatility

over [0, ]:
1
( ):= ( )
• (.‾) and Cov(. ) are respectively the sample average and sample covariance
of any function between 0 and :
1 1
‾:= ( ) , Cov( , ) : = ( ) − ‾ ( ( ) − ‾) .
• : = ∂ / ∂ is the option’s vega
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This formula contains five components:

 The volatility premium component is proportional to the volatility
premium (0) − ( ). We shall call the term that scales the volatility
premium:
( ) + (0)
∗
2
the volatility premium scaling factor. In practice, that term’s average
revolves around the inception Vega, as we shall see later.
 The gamma covariance effect, which can be thought of as a corrective
term for the volatility premium component when gamma and realized
volatility are correlated.
 The vega term, which is roughly equal to the unwind Vega times the
change in implied volatility since inception.
 A term in dGamma, and one last term which the authors call the residual
drift term. In (Daviaud & Mukhopadhyay, 2022), the authors found that
these last two terms did not contribute much to performance on average.
Applying that formula to SPX options

Can this new tool shed light on the factors driving the P&L of delta hedged SPX
options? In what follows, we apply this decomposition to at-the-money vanilla SPX
options since 2006. For each backtest, the option’s delta is recalculated and
rebalanced once a day, using Black-Scholes and live implied volatility. Each option
is held to maturity and then rolled. We ignore transaction costs at this stage: for the
time being, we are focused on understanding P&L and leave attempts at maximizing
alpha to another section.
For a one-month ATM put, the historical contribution of the five components looks
like this, from the perspective of the option seller:
Figure 1: Under the hood: historical contribution of the PnL components for vol sellers
1
0.8
0.6
$PnL for $1 total Vega sold.
0.4
0.2
-0.2
-0.4
-0.6
May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-14 May-15 May-16 May-17 May-18 May-19 May-20 May-21
VolPremiumTerm gammaCovarianceTerm dGammaTerm residualDriftTerm
Actual PnL Actual PnL vs decomposition VolPremium
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Figure 2 below shows the average contribution of each component as well as the
average total P&L to expiry for options with maturities 1w, 1m, 3m and 12m. Each
option is scaled to $1 Vega at inception, and again the perspective is that of the
option seller.
Figure 2: Breakdown of the average P&L across the four components (option seller’s
perspective)
2.5
2
1.5
0.5
-0.5
-1
1w 1m 3m 12m
VolPremiumTerm gammaCovarianceTerm dGammaTerm residualDriftTerm Actual PnL vs decomposition VolPremium Actual PnL
The dash marker shows the actual P&L of the strategy. The dark grey block shows
the difference between that actual P&L and the total P&L generated by our
attribution formula. The other four blocks show the P&L arising from the four
components described by our equation. Note that we have omitted the Vega term: per
its definition, it is zero when the option is held to maturity, since it is proportional to
the option’s Vega and since Vega is uniformly zero at expiry. Finally, the cross sign
shows the average volatility premium, defined as implied volatility at trade inception
minus realized volatility over the life of the option.
There are a few immediate takeaways from this chart. The first one is that the
volatility premium term, in blue, does not track the volatility premium too well, on
average. The second is that the largest contributor is not the volatility premium term,
but the covariance effect. As we can see on Figure 3 below, these two components –
the volatility premium term and the gamma covariance effect – are also the two most
volatile ones.
(33-1) 4015 4133 10 November 2022
Figure 3: The volatility premium term and the covariance effect are the two most volatile
contributors
12
Standard deviation of $ PnL contribution for $1 Vega at inception

10
0
1w 1m 3m 12m
VolPremiumTerm gammaCovarianceTerm dGammaTerm residualDriftTerm
Zooming in on the volatility premium

component
The volatility premium component can only be useful ex-ante if we have some
insight into its distribution, or that of its two components: the volatility premium
scaling factor, and the volatility premium itself.
The volatility premium is equal to implied volatility at trade date minus future
realized volatility. Therefore the future distribution of the volatility premium is solely
a function of the future realized volatility, itself the subject of an abundant literature.
To tackle the distribution of the volatility premium scaling factor, (Daviaud &
Mukhopadhyay, 2022) points out that in a risk neutral world, the discounted dollar
gamma is a martingale, and therefore that in that context the expected value of Γ ∗ is
equal to Γ ∗. This heuristic is only an approximation: it applies when the gamma in
the formula is equal to the (risk neutral) model’s gamma. In our case, we use the
Black-Scholes gamma instead. Furthermore, knowing the risk neutral expectation of
Γ ∗ is not sufficient: the volatility premium scaling factor is equal to the product of Γ ∗
and an average of inception implied vol and future realized vol. Therefore the
expectation of the latter, and the correlation between these two blocks, also feed into
the equation. Finally, it is the physical expectation, and not the risk neutral
expectation, that we are ultimately interested in.
In spite of all these caveats, the rule of thumb that the expected value of the volatility
premium scaling factor should be equal to ∗ (σ + σ )/2 and therefore should be
close to Vega at inception (see (Daviaud & Mukhopadhyay, 2022)) seems to hold up
reasonably well in practice. For $1 Vega at inception, this is what the average
volatility premium scaling factor looked like using our backtest window (2006-
2021):
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Table 1: Average Volatility Premium Scaling Factor

1w 1m 3m 12m
Volatility Premium Scaling Factor ($) 0.94 1.03 1.01 1.01
Beyond the expected value of the volatility premium scaling factor, another
parameter which will drive the volatility premium term is the correlation between the
volatility premium scaling factor and the volatility premium. When that correlation
revolves around zero, the volatility premium term behaves like a volatility swap on
average, as its expected value is then close to Vega at inception (see above) times the
expected volatility premium. In (Daviaud & Mukhopadhyay, 2022), the authors find
that for currency options that correlation is relatively small on average. For SPX
options, we find that this is not as clear cut:
Table 2: Average correlation between vol premium scaling factor and vol premium
1w 1m 3m 12m
Correl Vol Prem Scaling Factor/Vol Prem -34% -12% -16% -31%
In other words, the volatility premium scaling factor tends to decrease (so increase in
absolute term, since we’re taking the point of view of the option seller) when realized
volatility increases. This means less exposure when the volatility premium is high
and vice versa, and therefore less P&L on average. This largely explains why, as
noticed earlier, the volatility premium term does not track the volatility premium
well. Note that by most standards these correlation numbers aren’t very high, as
Figure 4 illustrates, but numerically they are significant enough to induce a bias.
Figure 4: For the 1m tenor, vol premium and the volatility premium scaling factors aren’t very
correlated.
2
1.8
1.6
Volatility premium scaling factor ($1 Vega at inception)
y = 0.0046x + 1.0357
1.4
1.2
0.8
0.6
0.4
Volatility premium
0.2
0
-20 -10 0 10 20 30 40 50 60 70 80
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The elephant in the room: the gamma

covariance effect
Let us now move our focus to the gamma covariance effect. While we treat it here in
a general framework, it can be easily understood in the special case where implied
volatility is constant. In that case, the total P&L of the delta hedged option can be
written as the gamma weighted sum of the difference between the instantaneous
realized variance (also known as the squared log returns) and the squared implied
volatility. The gamma covariance effect is what makes it possible for an option seller
to lose money even when volatility realizes below implied. In other words, in this
simple Black Scholes case, the gamma covariance effect is the difference between
the actual P&L and what one would make or lose if gamma were constant. Our
colleagues summarized this in their 2005 publication Just what you need to know
about variance swaps (Bossu, Strasser, & Guichard, 2005).
Figure 5: "Hammered at the strike": a 2005 illustration of the Gamma Covariance effect.
Source: J.P. Morgan Strategy.
Going back to the general case where implied volatility is no longer constant, Figure
2 tells us that the gamma covariance effect is the largest performance contributor, at
least over our backtest window and for the at-the-money options that we considered.
It is also the second most volatile contributor, as per Figure 3. Importantly, it impacts
performance through different channels, depending on the tenor. This is something
that (Daviaud & Mukhopadhyay, 2022) observed with Foreign Exchange options,
and we reached similar conclusions here with SPX options. Specifically, the gamma
covariance effect is detrimental to performance, from the option seller perspective,
when the option is short-dated, and boosts performance for long-dated tenors.
10
(33-1) 4015 4133 10 November 2022
Figure 6: Gamma covariance effect - historical contribution across tenors, option seller’s
perspective.
2
1.5
$PnL, total $1 Vega sold over backtest window

1
0.5
-0.5
-1
May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-14 May-15 May-16 May-17 May-18 May-19 May-20 May-21
1w 1m 3m 12m
Furthermore, the performance contribution for short-dated tenors (weekly options, in

our example) looks very much drift-like, whereas for longer dated maturities it is
fatter tailed, as one can see on Figure 6, and mostly kicks in in time of market shock.
That last feature means that the contribution of the gamma covariance effect mostly
disappears when we exclude the three main systemic shocks from the backtest: Fall
2008, summer 2011 and Feb/March 2020 (Figure 7). For 1w options, where the
effect is more drift-like per Figure 5, the gamma covariance effect remains a strong
contributor even after we remove these shocks.
Figure 7: When systemic shocks are excluded, the gamma covariance effect for 1m+ options
dwindles.
4
3.5
3
2.5
1.5
0.5
-0.5
-1
1w 1m 3m 12m
VolPremiumTerm gammaCovarianceTerm vegaTerm dGammaTerm residualDriftTerm Actual PnL vs decomposition VolPremium Actual PnL
To better understand the behavior of the gamma covariance effect in times of market
shock, let’s zoom in on the performance of a 3m option during the March 2020
11
(33-1) 4015 4133 10 November 2022
equity sell off. Figure 8 summarizes the contribution of the various P&L components
throughout that period, for a 3m option entered into at the end of December. As
realized volatility surged towards the end of February, the volatility premium
component became strongly negative. Meanwhile, the gamma covariance effect
surged.
Figure 8: Short 3m ATM put during the March 2020 equity selloff: gamma covariance effect
offsets most of vol premium contribution.
60
40
$PnL, $1 Vega at inception, 3m ATM put
20
-20
-40
-60
-80
23-Dec-19 23-Jan-20 23-Feb-20
VolPremiumTerm gammaCovarianceTerm vegaTerm
dGammaTerm residualDriftTerm diffNewActual
That effect makes sense intuitively. The spike in volatility came with a drop in the
underlying, making the option deeply in the money. Consequently, its Greeks
dwindled. Since we are short the option in this example, this means that Gamma rose
as realized volatility rose, and therefore that these two variables were positively
correlated, as Figure 9 illustrates. But this correlation is exactly what the gamma
covariance effect measures, hence that component’s surge during that period.
Figure 9: As realized volatility surged, gamma dwindled (in absolute terms)

0 0.012
-5000 0.01
Instantaneous realised variance (i.e. squared returns), SPX
$ Cash Gamma, $1 vega at inception
-10000 0.008
-15000 0.006
-20000 0.004
-25000 0.002
-30000 0
23-Dec-19 6-Jan-20 20-Jan-20 3-Feb-20 17-Feb-20 2-Mar-20 16-Mar-20
cashGamma (LHS) Instantaneous realised variance (RHS)
12
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Decomposing the gamma covariance effect

In the appendix, we tackle the gamma covariance effect from a more theoretical
angle and attempt to calculate its expectation in the risk neutral measure.
To do this, we build on the following intuition. When the underlying follows Black-
Scholes dynamics, the Black Scholes cash gamma is proportional to the probability
of expiring at the strike. Being the expected value of an expiry payoff (think of a
narrow rectangle around the strike), this quantity lends itself well to calculations.
When the underlying no longer follows Black Scholes, however, the Black Scholes
cash gamma is not equal to that probability. But perhaps is it a good approximation?
To assess this, we split the Black Scholes cash gamma into four components, with
one of them being the probability of expiring at the strike:
∗ ∗
∂ ∂ ∂ ∂ ∂
= −2 − −
∂ ∂ ∂ ∂ ∂
(3)
Here ∗ is the probability of expiring at the strike, and is the option’s Black-
Scholes vega. Importantly, ∗ is a model-free quantity: as we see in the appendix, it
can be interpreted as the price of a (narrow) option butterfly around the strike K. We
show in the appendix that its average contribution to the gamma covariance effect is
equal to
[Gamma Covariance Effect ]

∗ (0)
−
= ( , )− ( , ) ∣ =
2
(4)
where
1
( , )≡ ( ) and ( , )≡ ( ( , )|ℱ ).
( − )
That is, it is the excess variance (i.e. the difference between the ex-post realized
variance and the ex-ante variance swap rate) that one observes when the option
expires at the strike.
In a way this formula is reminiscent of the static replication argument (see (Carr &
Madan, 2001) which expresses the variance swap strike as a linear combination of
vanilla options. Our relationship here goes the other way: it expresses part of a
vanilla option’s returns as a function of variance swap rates and realized variance. In
the appendix, we expand on that theme a little further.
Figure 10 below shows the contributions from the four constituents of the gamma
covariance effect in our backtest window. We have labeled each contribution based
on the Greek that underpins it in the decomposition above, regardless of whether or
not that Greek is the dominating factor in the corresponding block. Based on these
two samples, the fraction of gamma coming from the probability of expiring at the
strike seems to be the main contributor, and the main driver of volatility. The
contribution from the term in dVega/dStrike is significant for the 1m option, and
13
(33-1) 4015 4133 10 November 2022
very much drift like. Within that term, preliminary results seem to indicate that it is
dVega/dStrike, rather than dSigma/dStrike, which is behind the covariance. This
could be because dVega/dStrike is proportional to moneyness, in log terms, and one
would not be surprised to see some correlation between moneyness and realized
variance, with realized variance being higher when the forward drops below the
strike and vice versa.
For 1w options, however, the main contributor is the fraction of gamma linked to the
probability of expiring at the strike, which from the equation above is linked to the
excess variance realized when expiring at the strike. Ignoring risk premium for a
minute, since that equation uses the risk neutral measure whereas the chart below
effectively relies on the empirical measure, what these tracks tell us is that when the
option expires near the money, realized variance is typically greater than the variance
swap predicted. This is perhaps a little counterintuitive, as one would imagine that
remaining near the strike would be a symptom of low volatility, if anything. What
may be at play here is that for short-dated option, the skew is very steep and
therefore the implied returns distribution of the underlying is very lobsided. This
means that the node is the distribution (i.e. its median) is above the strike. If we
follow this logic, conditioning on expiring near the strike means conditioning on a
risk-off scenario. This may explain why the gamma covariance effect is persistently
negative for short-dated options.
Figure 10: The gamma covariance effect is mostly driven by Gamma’s fly component (here with 1m and 1w ATM, seller’s perspective)
0.5 0.1
0
0.4
-0.1
$PnL for total $1 vega sold, 1m ATM option
$PnL for total $1 vega sold, 1w ATM option
0.3
-0.2
0.2 -0.3
0.1 -0.4
-0.5
0
-0.6
-0.1
-0.7
-0.2 -0.8
Gamma cov. effect Contrib. from prob. Strike Gamma cov. effect Contrib. from prob. Strike
Contrib. from dVegadStrike Contrib. from Vega Contrib. from dVegadStrike Contrib. from Vega
Contrib. from Volga Contrib. from Volga
14
(33-1) 4015 4133 10 November 2022
What about out of the money options?

So far, we’ve only considered at the money options in our analysis, but the volatility
premium is also central to any strategies involving out of the money options. In the
two charts below, we apply our P&L attribution technique to a 1m, 25 delta SPX put.
Figure 11: Out of the money puts do capture the volatility premium, but only a fraction of it (here with 1m 25 delta puts)
4 1.2
Average terminal P&L in $ for $1 Vega sold at inception (1m 25d puts)
3.5 1
$Pnl for 1m 25D puts. $1 Vega sold over backtest period.

3 0.8
2.5 0.6
2
0.4
1.5
0.2
1
0
0.5
-0.2
0
-0.4
-0.5
-0.6
-1
1w
VolPremiumTerm gammaCovarianceTerm vegaTerm VolPremiumTerm gammaCovarianceTerm
dGammaTerm residualDriftTerm Actual PnL vs decomposition dGammaTerm residualDriftTerm
VolPremium Actual PnL FullPnL Full PnL vs decomposition
The volatility premium for put strikes is high, but puts only
capture a fraction of it
The first takeaway is that the volatility premium here is much higher than what we
have seen so far: roughly 3.5 volatility points on average. Our strategy approximately
captures one third of it, as one can read from the level of the volatility premium term.
There are two main reasons behind this low monetization rate. The first one is that
the correlation between the volatility premium scaling factor and the volatility
premium is quite high here, at around 50%. This makes sense intuitively: periods
when the vol premium is low (i.e. realized vol is high) correspond to risk-off periods
when the underlying drops and comes closer to the out-of-the-money strike, making
gamma very negative. That dynamic didn’t exist for ATM options. The second factor
is that the expectation of the volatility premium scaling factor is smaller than 1,
averaging around 0.83 in our case. This means that for $1 of inception Vega
invested, one is exposed to $0.83 times the volatility premium on average. As Table
1 showed, that number is 1.03 in the case of 1m ATM options.
The second takeaway is that the gamma covariance effect contributes less to
performance than in the case of 1m ATM options (in absolute terms), and that its
contribution is now negative.
Besides, the strategy no longer benefits from the convexity effect which we observed
for all tenors in the case of ATM options and which caused the strategy to
15
(33-1) 4015 4133 10 November 2022
outperform its explained PnL on average. Indeed on Figure 2, the contribution from
‘Actual PnL vs decomposition’ is positive for all tenors, whereas on Figure 11 it is
negative. That’s because the decomposition effectively proxies the P&L profile with
a parabola. When the underlying is around the money, gamma is near its minimum
(hence its maximum in absolute terms), and this approximation is conservative. That
heuristic no longer applies when the strike is out of the money.
Conversely, the vol premium for calls is negative but the

gamma covariance effect makes up for it
Moving to the other side of the smile, Figure 12 below shows what the attribution
results look like for 25-delta calls. The strategy turns in a profit, but in a very
different way: the vol premium here is negative, and so is the volatility premium
term. But the gamma covariance effect is positive, and more than offsets losses from
the volatility premium. The contrast between Figure 11 and Figure 12 is consistent
with the approximation for the expected gamma covariance effect that we provide in
the appendix.
Figure 12: Selling 25d calls generates profits too, but in a very different way
4 2.5
Average terminal P&L in $ for $1 Vega sold at inception (1m 25 calls)
2
$Pnl for 1m 25D calls. $1 Vega sold over backtest window.
3
1.5
2
1
1 0.5
0
0
-0.5
-1
-1
-2 -1.5
-2
-3
1w
VolPremiumTerm gammaCovarianceTerm dGammaTerm VolPremiumTerm gammaCovarianceTerm
residualDriftTerm Actual PnL vs decomposition VolPremium dGammaTerm residualDriftTerm
Actual PnL FullPnL Actual PnL vs decomposition
That formula tells us that, in a risk neutral world at least, the gamma covariance
effect should be roughly equal to the variance conditional on expiring at the strike,
minus the unconditional variance. For an OTM put, this number should be positive,
and for an OTM call, it should be negative: the realized variance is likely to be
higher when the market sells off, and likely to be lower when it rallies. Since we are
selling options here, that logic is flipped (negative gamma covariance effect for the
put and vice versa). This is consistent with the signs of the gamma covariance P&L
in Figure 11 and Figure 12, and further confirmed when we look at the breakdown
of the gamma covariance effect.
Figure 13 below shows that breakdown for the same 25 delta 1m puts and calls. Here
again, we label each contributor based on the Greek that underpins it in ( 3 ). ∗ is
16
(33-1) 4015 4133 10 November 2022
the main contributor for both the puts and the calls, and contributes negatively to the
put’s performance, and positively to the call performance, all from the volatility
seller perspective.
∗
Figure 13: The contribution of to the Gamma covariance effect is negative for OTM puts, positive for calls (option seller perspective)
0.4 3.5
0.3
3
0.2
2.5
$PnL for total $1 vega sold, 1m 25d calls

$PnL for total $1 vega sold, 1m 25d puts
0.1
2
0
-0.1 1.5
-0.2 1
-0.3
0.5
-0.4
0
-0.5
-0.5
-0.6
-0.7 -1
Gamma cov. effect Contrib. from prob. Strike Gamma cov. effect Contrib. from prob. Strike
Contrib. from dVegadStrike Contrib. from Vega Contrib. from dVegadStrike Contrib. from Vega
Contrib. from Volga Contrib. from Volga
Risk-reversals: from local to global

Subtracting Figure 11 from Figure 12 gives us the P&L decomposition of a so-called
risk-reversals, a trade which consists in selling out of the money puts and buying out
of the money calls. The heuristic behind that trade is reminiscent of the one behind
simple volatility selling trades. Just like locally, the P&L from a delta hedged option
is proportional to the (squared) realized volatility minus implied volatility, the P&L
from a risk reversal can be linked to the differential between the realized spot/vol
correlation and its implied counterpart, inferred from the slope of the volatility smile.
This differential is called the skew premium.
(Ravagli, 2022) studies this mechanism in depth for currency pairs and finds that in
most cases (Exhibits 15 and 16), risk reversal trades initiated to harvest the skew
premium and held to maturity are profitable. (Ravagli, 2022) also points out that “the
impact of spurious Greeks such as Gamma and Vega can be significant, and be the
PnL main driver when large imbalances in such Greeks build up over the option’s
life”. This explains why outliers exist. Risk reversal trades on AUDJPY, for
example, are not profitable when held to maturity (see Exhibit 20).
In summary, even though the risk profile of unmanaged risk reversals changes with
time, and eventually diverges from the initial pure skew exposure, the initial impulse
is strong enough to carry the trade over to the finish line and generate positive
performance.
What Figure 11 and Figure 12 bring to this discussion is that they illustrate, from a
global perspective, how and when such trades may come off short. The two main
17
(33-1) 4015 4133 10 November 2022
performance offsets in these charts are the low volatility premium monetization for
the put, and the gamma covariance effect for the call. While it is unclear at this stage
how one can curtail the gamma covariance effect, the put’s monetization rate is likely
impacted by scenarios when the underlying ventures near the put’s strike, as
explained earlier. To mitigate such scenarios, one could envision a dynamic variant
of the risk reversal where one exits the trade when it reaches a certain moneyness
threshold on either side.
More broadly, these results argue in favor risk managing such trades, a conclusion
not only consistent with (Ravagli, 2022) but also with (Silvestrini & Afsah, 2019)
who improve significantly on the P&L (Figure 9) of a 3m 25 delta Eurostoxx risk
reversal when Vega hedging daily (Figure 10 in their piece).
A first foray into relative value

So far, our decomposition has allowed us to better understand how the volatility
premium contributes to performance, and has shown that in several instances the
main contributor isn’t the volatility premium but another quantity which we call the
gamma covariance effect.
Is there a way to turn this insight into an alpha-generating strategy? One avenue
could be try and isolate the gamma covariance effect. Take the 3m tenor, for
example, for which the average gamma covariance effect is sizable. Can we
neutralize or mitigate the contribution from the volatility premium, so as to be left
with the gamma covariance effect alone?
Idea #1: using a vol swap to neutralize the vol premium

component
On the topic of volatility premium one instrument typically comes to mind: the
volatility swap. At expiry, a volatility swap pays the realized volatility on the
underlying minus a price agreed upon at inception, typically called the strike. For
more background on these instruments, please refer to (Kaplan & Silvestrini, 2010).
If the volatility swap is a pure volatility premium instrument, it is worth highlighting
that the volatility premium that it captures is not the same as that of an ATM vanilla
option for example: because it is a derivative on the variance swap, the volatility
swap’s price depends on the volatility of all the strikes, and typically trades at a
premium above ATM volatility. As a result, the volatility premium that it captures is
typically greater than that of an ATM vanilla.
18
(33-1) 4015 4133 10 November 2022
Figure 14: Going long a 3m volatility swap vs short a 3m ATM option: the negative drift of the
volatility swap is too punitive.
2
$PnL, $1Vega investsed cumulatively over period

0
-1
-2
-3
-4
Vol Premium PnL gamma Covariance PnL 3m ATM, total PnL

3m vol swap PnL Vol swap minus 3m ATM, PnL
This explains why our relative value idea fails: the volatility swap’s negative drift is
more important than that of the vanilla option’s, itself inherited from the volatility
premium term. As a result, even though the trade does capture the gamma covariance
effect, it suffers from a strong negative drift.
Idea #2: term structure relative value

Another approach to isolate the gamma covariance effect, is to trade one tenor versus
another, taking advantage of the fact that the gamma covariance effect exhibits
different patterns for short and long dated tenors. Judging from Figure 2, the 1w and
3m tenors are good candidates since they seem to have similar levels of monetizable
volatility premium, and since their respective gamma covariance effect contributions
have opposite signs. The two charts below show what we obtain when we go long
one (the 1w) versus the other (the 3m), ignoring transaction costs for the time being.
19
(33-1) 4015 4133 10 November 2022
Figure 15: Going long a 1w ATM put vs short a 3m ATM put

2.00 2.5
$Pnl for 1w vs 3m. $1 Vega invested cumulatively for each leg.

2
1.50
$Pnl for $1 cumulative invested vega for each leg
1.5
1.00 1
0.5
0.50
0
-0.5
0.00
-1
-0.50
VolPremiumTerm gammaCovarianceTerm
dGammaTerm residualDriftTerm
Short 3m vs long 1w Short 3m FullPnL Actual PnL vs decomposition
The chart on the left shows the track for that strategy, compared with that of a simple
short 3m ATM put. The performance is a little smoother (0.9 Sharpe, vs 0.8 for the
3m), and the drawdowns shallower. The long 1w option can be a potent hedge during
crises, as the left side of Figure 15 below shows.
Not only has the trade’s performance improved, but its nature has also changed. It no
longer monetizes the volatility premium, but feeds on the gamma covariance effect,
as the right chart on Figure 15 illustrates. Once we factor costs in (Figure 16, right
side), the comparison with the 3m trade becomes less favorable as 1-week options
are expensive to trade and to dynamically delta hedge. Nevertheless, the performance
remains positive, which is noteworthy given that the package is cumulatively vega
neutral, and is unlikely to exhibit much of a negative gamma bias.
20
(33-1) 4015 4133 10 November 2022
Figure 16: Performance in 2008, and performance after costs.

0.40 2
0.30 1.5
$PnL for $1Vega invested in total over backtest window

$PnL for $1 Vega invested over 2006-2021
0.20
1
0.10
0.5
0.00
0
-0.10
-0.5
-0.20
-1
May-06
May-07
May-08
May-09
May-10
May-11
May-12
May-13
May-14
May-15
May-16
May-17
May-18
May-19
May-20
May-21
-0.30
Long 1w Short 3m 1w ex costs

Short 3m Long 1w 3m ex costs 1w vs 3m 1w-3m ex costs
Appendix
Accounting equation with forwards
Let be the price of a vanilla option as a function of time and of the forward price
:
( )
( , )= ,
Over a small time interval , the P&L of a vanilla option delta hedged with the
forward contract is equal to
∂
( )−
∂
Expanding the various terms, and assuming implied volatility doesn’t move, this
becomes
∂ ∂ 1∂ ∂
− + + + ⟨ ⟩−
∂ ∂ 2∂ ∂
(5)
Now satisfies the Black-Scholes equation
∂ 1 ∂
+ − =0
∂ 2 ∂
Moving this back into ( 5 ) and removing the offsetting terms, we get
1∂
P&L = ( ⟨ ⟩− )
2∂
21
(33-1) 4015 4133 10 November 2022
If we relax the assumption that implied volatility is constant, three extra terms enter
the equation:
1∂ ∂ ∂ ∂
P&L = ( ⟨ ⟩− )+ + ⟨ , ⟩+ ⟨ ⟩
2∂ ∂ ∂ ∂ ∂
This equation is identical to equation (3) in (Daviaud & Mukhopadhyay, 2022):

hedging with forward instead of spot has no impact on the decomposition.
A key insight in (Daviaud & Mukhopadhyay, 2022) is to rewrite the vega term above
using the equality
∂ ∂
= ( − )
∂ ∂
This leads to a number of cascading effects, one of them being that , in the first
block of the P&L equation above, is replaced by , the implied volatility at trade
inception. Rearranging the various blocks and integrating from inception to an
arbitrary time , the authors obtain:
Gamma covariance effect
⎡
( ) + (0)
& [ , ] = ⎢⎢ ∗ ( ) − (0) + Cov ∗ (. ), (. )
⎢ 2 2
⎣
Vega term dGamma term
+ ( − )
+ ( )( − )− ( − ) ∗
2 2
Residual drift term
∂ ⎤
+ − ⟨ ⟩⎥
2 ∂ ⎥
⎦
(6)
where
∗
• := is the discounted dollar gamma
• is the implied volatility
• is the instantaneous realised volatility of , and the realised volatility

over [0, ]:
1
( ):= ( )
• (.‾) and Cov(. ) are respectively the sample average and sample covariance
of any function between 0 and :
1 1
‾:= ( ) , Cov( , ) : = ( ) − ‾ ( ( ) − ‾) .
• : = ∂ / ∂ is the option’s vega
22
(33-1) 4015 4133 10 November 2022
Apprehending the Gamma covariance effect

In (Daviaud & Mukhopadhyay, 2022), the author’s calculations take place in a
probability weighted space ℙ, , (ℱ , ∈ [0, ]) where all path quantities ( , , etc)
are functions of time and of an outcome . Let’s denote the risk neutral
expectation over that space, and the product measure of and time over [0, ],
i.e. for any function :
1
( )≡ ( , ) .
Similarly let Cov denote the covariance based on that product measure. We shall
also use and Cov for the expectation and covariance over time, i.e. over [0, ].
Remember that ∗ is the cash gamma of the underlying, and that denotes its
instantaneous variance.
By the law of total covariance we have

∗ ∗ ∗
Cov ( , )= Cov ( , | ) + Cov ( | ), ( | )
(7)
Up to a ( /2) factor the middle term above is the expectation of the gamma
covariance effect, defined as
∗
Cov ( , )
2
(8)
That’s because for any function ( , ), Cov ( | ) = Cov (. , ) . Now the left
side of ( 7 ) is equal to
∗ ∗ ∗)
Cov ( , )= ( )− ( ( ),
(9)
while the last block of ( 7 ) is equal to
( ∗ ∗
Cov | ), ( | ) = (| ) ( | )
− ( ∗| ) ( | )
= ( ∗| ) ( | )
− ( ∗) ( )
( 10 )
Bringing ( 7 ), ( 9 ) and ( 10 ) together we get

∗ ∗ ∗
Cov ( , | ) = ( )− ( | ) ( | )
( 11 )
Breaking ∗ into three components

We will know introduce ∗ , defined as times the probability of expiring at the
23
(33-1) 4015 4133 10 November 2022
strike. ∗ can be seen as a component of ∗ as we shall see below. It is also a

martingale, and as such lends itself well to the calculation of expectations.
Following (Daviaud & Mukhopadhyay, 2022), we denote ( , , , , ) the time-

Black Scholes price of a call option with expiry , strike and volatility . We also
use PDF ( ) for the probability density function of the underlying at time . We
have
1 ∗
≡ ( )
= PDF ( ) ( )
∂
= ∫ PDF ( ) ( − )
∂
∂
= ∫ PDF ( )( − )
∂
∂
= ( , , , )
∂
( 12 )
where ( , , , ) ≡ ( , , ( ), , ) is the market price of our option. Note

that ∗ is a martingale, as it is the present value of a payoff, and as such should lend
itself well to the calculation of expectations. It is also a model-free market
observable, as the second derivative of can be thought of as the price of a narrow
option butterfly centered around . Now
∂ ∂ ∂ ∂
= +
∂ ∂ ∂ ∂
and therefore
∂ ∂ ∂ ∂ ∂ ∂ ∂ ∂
= +2 + +
∂ ∂ ∂ ∂ ∂ ∂ ∂ ∂ ∂
( 13 )
∗
Per (Daviaud & Mukhopadhyay, 2022), page 8, ∂ /∂ = ∂ /∂ = .
Therefore we can rewrite ( 13 ) as
∗
∂ ∂ ∂ ∂ ∂ ∂ ∂
= +2 + +
∂ ∂ ∂ ∂ ∂ ∂ ∂ ∂
∗
∂ ∂ ∂ ∂ ∂
= +2 + +
∂ ∂ ∂ ∂ ∂
( 14 )
Plugging that back in ( 12 ) we get

∗ ∗
∂ ∂ ∂ ∂ ∂
= +2 + +
∂ ∂ ∂ ∂ ∂
( 15 )
In other words,
24
(33-1) 4015 4133 10 November 2022
∗ ∗
∂ ∂ ∂ ∂ ∂
= −2 − −
∂ ∂ ∂ ∂ ∂
( 16 )
Resuming the calculation

We shall now substitute ∗ to ∗. This amounts to focusing on the contribution of
∗
to the covariance effect. Ignoring interest rates for the time being, the second
term of ( 11 ) becomes
1
( ∗ )= ∗( ) ( )
= ( ( )|ℱ ) ( )
= ( ( ) ( )|ℱ )
= ( ( ) ( )|ℱ )
= ( ) ( )
= ( ) ( )
( 17 )
Similarly, the last term of ( 11 ) is
∗
1 ∗
( | ) ( | ) = ( ) ( )
= ( ( )|ℱ ) ( )
= ( ( )|ℱ ) ( )
= ( ( )|ℱ ) ( ) |ℱ
= ( ) ( ) |ℱ |ℱ
= ( ) ( ) |ℱ
( 18 )
( 11 ), ( 17 ) and ( 18 )yield
∗
1
Cov ( , | ) = ( ) ( )− ( ) |ℱ
( 19 )
Focusing on the second part of that equation,
25
(33-1) 4015 4133 10 November 2022
1
( ) ( ) |ℱ
= ( ) ( ( )|ℱ )
= ( ) ( ( )|ℱ )
That last equation can be rewritten as
( ) ( − ) ( )+ ( ( )|ℱ )
− 1
= ( ) ( )+ ( ( )|ℱ )
− 1
= ( ) ( )+ ( ( )|ℱ )
( 20 )
Plugging ( 20 ) in ( 19 ) we get
∗
Cov ( , | ) = ( ) ( )− ( ( )|ℱ )
( 21 )
Now for any random variable (see step by step explanations after formula block),
( ( ) ) = ( ( ) | )
= ( ) ( | )
= ( ) ( | )
= ( ) ( | )
= ( ) ( ) ( | )
= PDF ( ) ( | )
= PDF ( ) ( | = )
( 22 )
where
• Line 3 follows from line 2 as the Dirac function is 0 away from ,
• Line 4 follows from line 3 as ( | ) is a constant,
• in line 5 is the probability density function of
• The last line is just another way to write the next-to-last line.
Applying ( 22 ) to ( 21 ) yields
26
(33-1) 4015 4133 10 November 2022
∗
Cov ( , | )
PDF ( )
= ( )− ( ( )|ℱ ) ∣ =
( 23 )
Introducing
1
( , )≡ ( ) and ( , )≡ ( ( , )|ℱ ),
( − )
( 24 )
Equation ( 23 ) can be rewritten as
Cov ( ∗ , | )
PDF ( )
= ( )− ( ( )|ℱ ) ∣ =
PDF ( )
= ( ( )− ( ( )|ℱ )) ) ∣ =
PDF ( )
= ( ( )− ( ( )|ℱ )) ) ∣ =
PDF ( )
= ( − ) ( , )− ( , ) ∣ =
PDF ( ) −
= ( , )− ( , ) ∣ =
( 25 )
∗ (0)
Multiplying by ( /2) per equation ( 8 ) and recalling that is by definition
equal to PDF ( ), ( 25 ) becomes
∗
Cov ( , | )
2
∗ (0)
−
= ( , )− ( , ) ∣ = .
2
( 26 )
( /2)Cov ( ∗ , | ) is the contribution of ∗ to the gamma covariance effect,

hereafter denoted (Gamma Covariance Effect) , and we can drop the superscript on
the expected value sign on the left side of ( 26 ), since the gamma covariance effect is
not a function of time but of the outcome only. This yields
[Gamma Covariance Effect ]
∗ (0)
−
= ( , )− ( , ) ∣ =
2
( 27 )
27
(33-1) 4015 4133 10 November 2022
Digression on the volatility premium component

We can use the same approach with the fraction of the volatility premium term that
comes from .
t ∗
1
Volatility premium component = ( ) −
2
( 28 )
Focusing on the first term on the right:
∗
1
( )
1
= ( ( )|ℱ ) ( )
1
= ( ( )|ℱ ) ( )
1
= ( ( )|ℱ ) ( ( )|ℱ )
1
= ( ( ) ( ( )|ℱ )|ℱ )
1
= ( ) ( ( )|ℱ )
1
= ( ) ( ( )|ℱ )
1
= ( ) ( ) + ( ( )|ℱ )
Using the notation introduced in ( 24 ) this is
∗
1
( )
1
= ( ) RV(0, ) + ( − )EV( , )
1 −
= ( ) RV(0, ) + EV( , )
∗ (0)
1 −
= RV(0, ) + EV( , ) | =
( 29 )
Now the side of ( 28 ) is equal to

∗ ∗ (0)
=
Together with ( 28 ) and ( 29 ) this gives
28
(33-1) 4015 4133 10 November 2022

∗ (0)
−
= RV(0, ) + EV( , ) | = −
2
Adding this to ( 27 ) gives
Volatility premium component + Gamma covariance effect

∗ (0)
−
= RV(0, ) + EV( , ) | = −
2
∗ (0)
−
+ ( , )− ( , ) ∣ =
2
∗ (0)
= RV (0, ) | = −
2
∗ (0)
= ( ( RV(0, )| = ) − )
2
∗ (0)
= ( ) | = −
2
( 30 )
To build intuition, we can see what happens if we assume that the -subscripted
components of the volatility premium component and of the gamma covariance
effect are the main drivers. In that case, if we solve ( 30 ) for zero, we get
1
( )≈ ( ) | =
( 31 )
where we made the dependency between and explicit. Summing over

according to the law of we get
1
( )PDF ( ) ≈ ( ) | = PDF ( )
1
= ( )
( 32 )
The right side is the fair strike of a variance swap. Using that PDF ( ) = ∗ / , as
we saw earlier, ( 32 ) leads to a formula that is similar - but not quite equal - to the
known formula that expresses the variance swap volatility in terms of the strike
volatilities (see (Bergomi, 2016), equation (4.21a), p142). That these two formulas
differ is not necessarily a surprise, since ( 31 ) is only an approximation.
29
(33-1) 4015 4133 10 November 2022
References
Bergomi, L. (2016). Stochastic Volatility Modeling. Chapman & Hall.
Bossu, S., Strasser, E., & Guichard, R. (2005). Just what you need to know about
variance swaps. J.P. Morgan report.
Carr, P., & Madan, D. (2001). Towards a theory of volatility trading. Option Pricing,
Interest Rates and Risk Management, Handbooks in Mathematical Finance, 458-476.
Daviaud, O., & Mukhopadhyay, A. (2022). Linking the performance of vanilla

options to the volatility premium. Risk.
Kaplan, B., & Silvestrini, D. (2010). Volatility Swaps. J.P. Morgan report.
Ravagli, L. (2022). Options Skew Risk Premium, How To Measure And Harvest It.
J.P. Morgan report.
Silvestrini, D., & Afsah, E. (2019). European Equity Derivatives Outlook,

Understand Skew Trading Strategies. J.P. Morgan report.
30
(33-1) 4015 4133 10 November 2022
Risks of Common Option Strategies

Risks to Strategies: Not all option strategies are suitable for investors; certain strategies may expose investors to significant potential
losses. We have summarized the risks of selected derivative strategies. For additional risk information, please call your sales
representative for a copy of “Characteristics and Risks of Standardized Options.” We advise investors to consult their tax advisors and
legal counsel about the tax implications of these strategies. Please also refer to option risk disclosure documents.
Put Sale: Investors who sell put options will own the underlying asset if the asset’s price falls below the strike price of the put option.
Investors, therefore, will be exposed to any decline in the underlying asset’s price below the strike potentially to zero, and they will not
participate in any price appreciation in the underlying asset if the option expires unexercised.
Call Sale: Investors who sell uncovered call options have exposure on the upside that is theoretically unlimited.
Call Overwrite or Buywrite: Investors who sell call options against a long position in the underlying asset give up any appreciation in
the underlying asset’s price above the strike price of the call option, and they remain exposed to the downside of the underlying asset in
the return for the receipt of the option premium.
Booster : In a sell-off, the maximum realized downside potential of a double-up booster is the net premium paid. In a rally, option losses
are potentially unlimited as the investor is net short a call. When overlaid onto a long position in the underlying asset, upside losses are
capped (as for a covered call), but downside losses are not.
Collar: Locks in the amount that can be realized at maturity to a range defined by the put and call strike. If the collar is not costless,
investors risk losing 100% of the premium paid. Since investors are selling a call option, they give up any price appreciation in the
underlying asset above the strike price of the call option.
Call Purchase: Options are a decaying asset, and investors risk losing 100% of the premium paid if the underlying asset’s price is below
the strike price of the call option.
Put Purchase: Options are a decaying asset, and investors risk losing 100% of the premium paid if the underlying asset’s price is above
the strike price of the put option.
Straddle or Strangle: The seller of a straddle or strangle is exposed to increases in the underlying asset’s price above the call strike and
declines in the underlying asset’s price below the put strike. Since exposure on the upside is theoretically unlimited, investors who also
own the underlying asset would have limited losses should the underlying asset rally. Covered writers are exposed to declines in the
underlying asset position as well as any additional exposure should the underlying asset decline below the strike price of the put option.
Having sold a covered call option, the investor gives up all appreciation in the underlying asset above the strike price of the call option.
Put Spread: The buyer of a put spread risks losing 100% of the premium paid. The buyer of higher-ratio put spread has unlimited
downside below the lower strike (down to zero), dependent on the number of lower-struck puts sold. The maximum gain is limited to the
spread between the two put strikes, when the underlying is at the lower strike. Investors who own the underlying asset will have downside
protection between the higher-strike put and the lower-strike put. However, should the underlying asset’s price fall below the strike price
of the lower-strike put, investors regain exposure to the underlying asset, and this exposure is multiplied by the number of puts sold.
Call Spread: The buyer risks losing 100% of the premium paid. The gain is limited to the spread between the two strike prices. The seller
of a call spread risks losing an amount equal to the spread between the two call strikes less the net premium received. By selling a covered
call spread, the investor remains exposed to the downside of the underlying asset and gives up the spread between the two call strikes
should the underlying asset rally.
Butterfly Spread: A butterfly spread consists of two spreads established simultaneously – one a bull spread and the other a bear spread.
The resulting position is neutral, that is, the investor will profit if the underlying is stable. Butterfly spreads are established at a net debit.
The maximum profit will occur at the middle strike price; the maximum loss is the net debit.
Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate of current market levels, and are not indicative
trading levels.
31
(33-1) 4015 4133 10 November 2022
Analyst Certification: The Research Analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple Research
Analysts are primarily responsible for this report, the Research Analyst denoted by an “AC” on the cover or within the document
individually certifies, with respect to each security or issuer that the Research Analyst covers in this research) that: (1) all of the views
expressed in this report accurately reflect the Research Analyst’s personal views about any and all of the subject securities or issuers; and
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JPM How Close To Realise 2022-11-10 4259949

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Global Quantitative &

How close to realised should

Dobromir Tzotchev, PhD

Source: J.P. Morgan Quantitative and Derivatives Strategy

Implied volatility trades around realized.

To understand where implied volatility should trade, we need a better accounting

Our piece is structured as follows. We first review the theoretical framework in

What is the P&L of a delta hedged option?

Let ( , , σ ) be the price of a vanilla option as a function of time , the forward

Now satisfies the Black-Scholes equation:

where ⟨ ⟩ denotes the instantaneous realized variance of F. If we relax the

• is the implied volatility

• is the instantaneous realised volatility of , and the realised volatility

• : = ∂ / ∂ is the option’s vega

This formula contains five components:

Applying that formula to SPX options

Source: J.P. Morgan Quantitative and Derivatives Strategy

Source: J.P. Morgan Quantitative and Derivatives Strategy

Standard deviation of $ PnL contribution for $1 Vega at inception

Source: J.P. Morgan Quantitative and Derivatives Strategy

Zooming in on the volatility premium

Table 1: Average Volatility Premium Scaling Factor

Source: J.P. Morgan Quantitative and Derivatives Strategy

The elephant in the room: the gamma

Source: J.P. Morgan Strategy.

$PnL, total $1 Vega sold over backtest window

Source: J.P. Morgan Quantitative and Derivatives Strategy

Furthermore, the performance contribution for short-dated tenors (weekly options, in

Source: J.P. Morgan Quantitative and Derivatives Strategy

Source: J.P. Morgan Quantitative and Derivatives Strategy

Figure 9: As realized volatility surged, gamma dwindled (in absolute terms)

Source: J.P. Morgan Quantitative and Derivatives Strategy

Decomposing the gamma covariance effect

[Gamma Covariance Effect ]

$PnL for total $1 vega sold, 1w ATM option

Source: J.P. Morgan Quantitative and Derivatives Strategy

What about out of the money options?

$Pnl for 1m 25D puts. $1 Vega sold over backtest period.

Source: J.P. Morgan Quantitative and Derivatives Strategy

Conversely, the vol premium for calls is negative but the

Source: J.P. Morgan Quantitative and Derivatives Strategy

$PnL for total $1 vega sold, 1m 25d calls

Source: J.P. Morgan Quantitative and Derivatives Strategy

Risk-reversals: from local to global

A first foray into relative value

Idea #1: using a vol swap to neutralize the vol premium

$PnL, $1Vega investsed cumulatively over period

Vol Premium PnL gamma Covariance PnL 3m ATM, total PnL

Source: J.P. Morgan Quantitative and Derivatives Strategy

Idea #2: term structure relative value

Figure 15: Going long a 1w ATM put vs short a 3m ATM put

$Pnl for 1w vs 3m. $1 Vega invested cumulatively for each leg.

Source: J.P. Morgan Quantitative and Derivatives Strategy

Figure 16: Performance in 2008, and performance after costs.

$PnL for $1Vega invested in total over backtest window

Long 1w Short 3m 1w ex costs

Source: J.P. Morgan Quantitative and Derivatives Strategy

Now satisfies the Black-Scholes equation

This equation is identical to equation (3) in (Daviaud & Mukhopadhyay, 2022):

• is the implied volatility

• is the instantaneous realised volatility of , and the realised volatility

• : = ∂ / ∂ is the option’s vega

Apprehending the Gamma covariance effect