Common Factors in Equity Option Returns

Abstract

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