Common Factors in Equity Option Returns

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