Common Factors in Equity Option Returns
55 Pages Posted: 7 Dec 2018 Last revised: 30 Aug 2022
Date Written: August 20, 2022
We study the factor structure of option returns and propose a parsimonious three-option-factor model that explains their time-series and cross-sectional variation. Using latent estimation techniques, we find that a model with three latent factors generates a correlation of 0.93 between average and predicted option returns and explains 0.77 of their time series variation. The latent factors are captured by three tradable option factors: the equal-weighted option portfolio return of the sample, the long-short factor sorted by the difference between historical and implied volatilities, and the one sorted by volatility of implied volatility. These option factors are uncorrelated with stock return factors.
Keywords: Cross-Section of Option Returns, PCA, Factor Model
JEL Classification: C14, G13, G17
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