FOREIGN EXCHANGE OPTIONS MARKETS INEFFICIENCY: THE ABNORMAL PROFITS GENERATED BY AN IMPLIED VOLATILITY BASED RULE

William C. Clyde and James Gislason

Since the vast majority of option trading is now done by trading the implied volatility that goes into option pricing, this study tests whether a simple implied volatility-based trading rule would generate abnormal profits. The strategy creates initially theoretically risk-free options positions know as straddles, which are held to expiration (the risk on each of these positions is only theoretically zero at initiation -- it is positive for the remainder of the holding period). Profits and losses are determined by comparing initial premium paid or received with the value of the straddle at expiration. The results are consistent with earlier rule based studies: Large and statistically significant profits are found to be realizable in the foreign exchange options markets for Deutsche marks, Japanese yen, British pounds, and Swiss francs. The study is then extended to try to identify the source or sources of these abnormal profits, exploring the possibilities that: 1) implied volatility is not a good predictor of realized volatile, and 2) absolute price movement is not predicted well by the level of realized volatility. The results are not conclusive, but indicate that price movement may be independent of volatility for a given period.