A Factor Model for Option Returns

Due to their short lifespans and migrating moneyness, options are notoriously difficult to study with the factor models commonly used to analyze the risk-return trade-off in other asset classes. Instrumented principal components analysis solves this problem by tracking contracts in terms of their pricing-relevant characteristics via time-varying latent factor loadings. We find that a model with three latent factors prices the cross-section of option returns and explains more than 85% of the variation in a panel of monthly S&P 500 option returns from 1996 to 2017. In particular, we show that the IPCA factors can be rationalized via an economically plausible three-factor model consisting of a level, slope and skew factor. Finally, out-of-sample trading strategies based on insights from the IPCA model have significant alpha over previously studied option strategies.

Keywords: Option Return; Factor Model; Return Predictability; IPCA

JEL Classification: G02, G12, G13

Suggested Citation: Suggested Citation

Büchner, Matthias and Kelly, Bryan T., A Factor Model for Option Returns (September 28, 2021). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=3444232 or http://dx.doi.org/10.2139/ssrn.3444232