Predictable Dynamics in the S&P 500 Index Options Implied Volatility Surface*

Abstract

Recent evidence suggests that the parameters characterizing the implied volatility surface (IVS) in option prices are unstable. We study whether the resulting predictability patterns may be exploited. In a first stage we model the surface along cross-sectional moneyness and maturity dimensions. In a second stage we model the dynamics of the first-stage coefficients. We find that the movements of the S&P 500 IVS are highly predictable. Whereas profitable delta-hedged positions can be set up under selective trading rules, profits disappear when we increase transaction costs and trade on wide segments of the IVS.