The Fear and Exuberance from Implied Volatility of S&P 100 Index Options

Abstract

I study the relation between option traders’ risk perception and contemporaneous market conditions. Risk perception tends to increase when downside volatility increases more than upside volatility. The risk‐return relation is asymmetric and nonlinear, best described as a downward‐sloping reclined S‐curve. That prior gains appear to have some mitigating effect on the fear of loss relative to prior losses points to a “house money” effect. Broader market conditions influence the perception of risk in a manner consistent with the “keeping up with the Joneses” effect. Leverage is a weak explanation for the risk‐return relation.

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