Stock Return Autocorrelations and Expected Option Returns

Abstract

We show that the return autocorrelation of underlying stock is an important determinant of expected equity option returns. Using an extended Black-Scholes model incorporating the presence of stock return autocorrelation, we demonstrate that expected returns of both call and put options are increasing in return autocorrelation coefficient of the underlying stock. Consistent with this insight, we find strong empirical support in the cross-section of average returns of equity options. Our paper highlights the necessity to control for stock return autocorrelation when studying option return predictability.

Keywords: stock return autocorrelation, expected option returns, cross-section of option returns, option portfolios

JEL Classification: G11, G12, G13