A Factor Model for Option Returns
62 Pages Posted: 5 Sep 2019 Last revised: 6 Oct 2021
Date Written: September 28, 2021
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