Common Factors in Equity Option Returns

Abstract

This paper studies the factor structure of the cross-section of delta-hedged equity option returns. We find that a four-factor model explains the cross-section and time-series of equity option returns. Out of the four factors, three are characteristic based factors from the long-short option portfolios based on firm size, idiosyncratic volatility, and the difference between implied and historical volatilities. The fourth factor is the market volatility risk factor proxied by the delta-hedged option return of the the S&P 500 index. Traditional stock return factors cannot price the cross-section of equity option returns.

Keywords: Cross Section of Option Returns, Latent Factors, Rank Estimation

JEL Classification: C14, G13, G17