Common Factors in Equity Option Returns
51 Pages Posted: 7 Dec 2018
Date Written: November 20, 2018
This paper studies the factor structure in the cross-section of delta-hedged equity option returns. Using latent factor techniques, we ﬁnd strong evidence for the existence of a factor structure in equity options returns. We propose a four-factor model, which captures relevant latent factors and explains the time series and cross-section of equity option returns. The factors are the market volatility risk factor and three characteristic-based factors related to ﬁrm size, idiosyncratic volatility, and the diﬀerence between implied and historical volatilities. 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
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