Stock Return Autocorrelations and the Cross Section of Option Returns

Abstract

We present a new finding between the cross-section of average returns of equity option and the return autocorrelations of underlying stocks. Extended Black-Scholes model incorporating the presence of stock return autocorrelation suggests that expected returns of both call and put options are increasing in return autocorrelation coefficient of the underlying stock. Consistent with this insight, we find strong empirical support in the cross-section of average returns of equity options. Average returns of calls and puts as well as average returns of straddles all show monotonically increasing relationship with the degree of underlying stock's return autocorrelation coefficient. Additional equity option portfolio analysis shows that the information on stock return autocorrelation helps investors to significantly improve the out-of-sample performance of their portfolios.

Keywords: stock return autocorrelation, cross-section of option returns, expected option returns, option portfolios

JEL Classification: G11, G12, G13