Understanding Index Option Returns

Review of Financial Studies, Vol. 22, No. 11, pp. 4493-4529, 2008

Columbia Business School Research Paper

48 Pages Posted: 20 Oct 2011  

Mark Broadie

Columbia University - Columbia Business School - Decision Risk and Operations

Mikhail Chernov

UCLA Anderson

Michael Johannes

Columbia University

Multiple version iconThere are 5 versions of this paper

Date Written: January 8, 2008

Abstract

Previous research concludes that options are mispriced based on the high average returns, CAPM alphas, and Sharpe ratios of various put selling strategies. One criticism of these conclusions is that these benchmarks are ill suited to handle the extreme statistical nature of option returns generated by nonlinear payoffs. We propose an alternative way to evaluate the statistical significance of option returns by comparing historical statistics to those generated by option pricing models. The most puzzling finding in the existing literature, the large returns to writing out-of-the-money puts, is not inconsistent (i.e., is statistically insignificant) relative to the Black-Scholes model or the Heston stochastic volatility model due to the extreme sampling uncertainty associated with put returns. This sampling problem can largely be alleviated by analyzing market-neutral portfolios such as straddles or deltahedged returns. The returns on these portfolios can be explained by jump risk premiums and estimation risk.

Suggested Citation

Broadie, Mark and Chernov, Mikhail and Johannes, Michael, Understanding Index Option Returns (January 8, 2008). Review of Financial Studies, Vol. 22, No. 11, pp. 4493-4529, 2008; Columbia Business School Research Paper. Available at SSRN: https://ssrn.com/abstract=1946412

Mark Broadie (Contact Author)

Columbia University - Columbia Business School - Decision Risk and Operations ( email )

New York, NY
United States
212-854-4103 (Phone)

Mikhail Chernov

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Michael Johannes

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

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