Improving Portfolio Selection Using Option-Implied Volatility and Skewness

Abstract

Our objective in this paper is to examine whether one can use option-implied information to improve the selection of mean-variance portfolios with a large number of stocks, and to document which aspects of option-implied information are most useful for improving their out-of-sample performance. Portfolio performance is measured in terms of volatility, Sharpe ratio, and turnover. Our empirical evidence shows that using option-implied volatility helps to reduce portfolio volatility. Using option-implied correlation does not improve any of the metrics. Using option-implied volatility, risk-premium, and skewness to adjust expected returns leads to a substantial improvement in the Sharpe ratio, even after prohibiting shortsales and accounting for transactions costs.

Keywords: mean variance, option-implied volatility, variance risk premium, option-implied skewness, portfolio optimization

JEL Classification: G11, G12, G13, G17