Volatility Risk Premium: The Growing Importance of Overnight and Intraday Dynamics

How the Volatility Risk Premium Varies Between Overnight and Intraday Sessions

Author

Nam Nguyen
February 23, 2025 • Estimated Reading Time: 9 minutes

The breakdown of the volatility risk premium into overnight and intraday sessions is an active and emerging area of research. It holds not only academic interest but also practical implications. ETF issuers are launching new ETFs to capitalize on the overnight risk premium, and the shift toward around-the-clock trading could impact the VRP and popular strategies such as covered call writing. In this issue, I'll discuss the VRP breakdown, its implications, impact, and more.

In this issue:

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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. Reference [1] examines the asymmetry in the VRP. Specifically, it investigates the VRP during the day and overnight sessions. The research was conducted in the Nifty options market, but previous studies in the S&P 500 market reached the same conclusion.

Findings

  • There is a significant difference in returns between overnight and intraday short option positions, unrelated to a weekend effect.

  • The return asymmetry decreases as option moneyness and maturity increase.

  • A systematic relationship exists between day-night option returns and the option Greeks.

  • Average post-noon returns are significantly negative for short call positions and positive for short put positions, while pre-noon returns are largely insignificant, indicating that the VRP varies throughout the trading day for calls and puts.

  • A significant jump in the underlying index reduces the day-night disparity in option returns due to increased implied volatilities, which boost both intraday and overnight returns.

  • Strong positive overnight returns suggest that the VRP in Nifty options prices mainly compensates for overnight risk.

  • A strategy of selling index options at the end of the trading day and covering them at the beginning of the next day yields positive returns before transaction costs but is not profitable after accounting for transaction costs.

Reference

[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

Inventory Risk and Its Impact on the Volatility Risk Premium

The previous paper suggests that the VRP is specifically a reward for bearing overnight risk. Reference [2] goes further by attempting to answer why this is the case. It provides an explanation in terms of market makers’ inventory risks, as they hold a net-short position in put options.

Findings

  • Put option risk premia are significantly negative overnight when equity exchanges are closed and continuous delta-hedging is not feasible.

  • Intraday, when markets are liquid and delta-hedging is possible, put option risk premia align with the risk-free rate.

  • Call options show no significant risk premia during the sample period.

  • Market makers’ short positions in puts expose them to overnight equity price “gap” risks, while their call option positions are more balanced between long and short, resulting in minimal exposure to gap risk.

  • Increased overnight liquidity reduces option risk premia. Regulatory changes and the acquisition of major electronic communication networks in 2006 boosted overnight equity trade volumes from Monday to Friday, reducing the magnitude of weekday option risk premia compared to weekend risk premia.

  • The study concludes that the S&P 500 option risk premium arises from a combination of options demand and overnight equity illiquidity.

An interesting implication of this research is that the introduction of around-the-clock trading could potentially reduce the VRP.

Reference

[2] J Terstegge, Intermediary Option Pricing, 2024, Copenhagen Business School

Practical Implications of the VRP

With the rise in popularity of short-dated options, especially among retail options traders, ETF issuers are capitalizing on this trend by launching new ETFs.

  • In this article, Michael H provides an excellent analysis of these newly issued ETFs and how the overnight VRP is embedded in their returns.

  • In this podcast, Ben Eifert discusses the launch of ETFs that incorporate derivatives, noting how institutions—traditionally reliant on simple, passive investments—are now integrating them into their core portfolios, how this shift happened, and what impact it is having on the market.

Closing Thoughts

Understanding the breakdown of the volatility risk premium into overnight and intraday components is crucial for both researchers and practitioners. As ETF issuers develop products to leverage the overnight risk premium and markets move toward 24-hour trading, these dynamics could significantly impact volatility strategies. Recognizing these shifts can help investors refine their approaches and adapt to evolving market conditions.

Educational Video

Master Volatility Options Trading

In this video, Euan Sinclair discusses the concept of VRP in depth and its relationship to options trading. He also covers broader topics in volatility trading:

  • A brief introduction to volatility and its importance in options trading

  • Understanding and using option pricing models

  • Methods for estimating volatility

  • Creating profitable volatility trading strategies

  • Interactive Q&A session

Volatility Weekly Recap

The figure below shows the term structures for the VIX futures (in colour) and the spot VIX (in grey).

Stocks erased their weekly gains on Friday as investors reacted to signs of a sluggish economy. The Dow and Nasdaq both dropped 2.5%, while the S&P 500 fell 1.7% for the week. Treasury yields declined, with the 10-year yield slipping and the two-year yield falling to 4.192%. Meanwhile, both spot VIX and futures rose, though VIX futures still remain in contango. This resulted in returns of 5.55% and 3.14% for VXX and VIXM respectively.

Around the Quantosphere

  • Volatility is 'mis-priced' says UBS. Expect that to change soon (marketwatch)

  • How Gambling Took Over America (currentaffairs)

  • Why top hedge funds are paying interns $25,000 a month: ‘They aren’t just doing coffee runs’ (fnlondon)

  • Odd Lots Podcast: How Banks Turned Into Giant Synthetic Hedge Funds (bloomberg)

  • Odd Lots Podcast: This Is How Derivatives Trading Swallowed the Entire Market (bloomberg)

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