Common Factors in Equity Option Returns

55 Pages Posted: 7 Dec 2018 Last revised: 30 Aug 2022

See all articles by Alex R. Horenstein

Alex R. Horenstein

University of Miami - School of Business Administration - Department of Economics

Aurelio Vasquez

Instituto Tecnológico Autónomo de México (ITAM) - Department of Business Administration

Xiao Xiao

City University London - Bayes Business School

Date Written: August 20, 2022

Abstract

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

Suggested Citation

Horenstein, Alex R. and Vasquez, Aurelio and Xiao, Xiao, Common Factors in Equity Option Returns (August 20, 2022). Available at SSRN: https://ssrn.com/abstract=3290363 or http://dx.doi.org/10.2139/ssrn.3290363

Alex R. Horenstein (Contact Author)

University of Miami - School of Business Administration - Department of Economics ( email )

P.O. Box 248126
Coral Gables, FL 33124-6550
United States

Aurelio Vasquez

Instituto Tecnológico Autónomo de México (ITAM) - Department of Business Administration ( email )

Rio Hondo No. 1
Col. Tizapan-San Angel, 01000
Mexico

Xiao Xiao

City University London - Bayes Business School ( email )

United Kingdom

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