Volatility Timing Using ETF Options: Evidence from Hedge Funds

We find that hedge funds’ positions in exchange-traded fund (ETF) options contain volatility information about underlying ETF returns. Greater hedge fund option demand predicts higher variance of ETF returns over the following quarter and on days of macroeconomic news. The predictive power holds for options on equity and non-equity (e.g., fixed income, currency) ETFs. A tracking portfolio of straddles based on funds’ straddle positions earns quarterly abnormal returns of 7.95%. Net of fees, funds using ETF straddles deliver lower risk and higher benchmark-adjusted returns than nonusers. We conclude that ETF options are an important venue for market volatility timing strategies.

Hedge funds exchange-traded funds options volatility timing