Volatility Mispricing in US Equity Option Markets

Recent research shows that volatility measurement errors are a prime source of mispricing in options markets. This allows investors to engage in trading strategies that earn abnormal rates of return. We conduct empirical research on US non-dividend paying American call options and perform a cross-sectional study of these stock option returns. We find that a zero-cost trading strategy that is long (short) in 2-month-to-expiry calls with relatively large positive (negative) difference between historical realized volatility and option implied volatility produces significant positive returns, but the same strategy applied to 1-month-to-expiry calls and delta-hedged calls does not.