Very Noisy Option Prices and Inferences Regarding Option Returns
56 Pages Posted: 3 Dec 2019
Date Written: November 15, 2019
We show that microstructure biases in the estimation of expected option returns and risk premia are large, in some cases over 50 basis points per day. We propose a new method that corrects for these biases. We then apply our method to real data and produce three main findings. First, the expected returns of straddles and delta-hedged options written on the S&P 500 Index are smaller than previously estimated in the literature. Second, delta-hedged options and straddles written on individual stocks have negative expected returns. Third, the price of individual equity volatility risk is about 45% of the price of market volatility. These findings show that the stylized finding that volatility is not priced in individual stock options is due to microstructure biases.
Keywords: Options, Liquidity, Microstructure bias
JEL Classification: G10,G12
Suggested Citation: Suggested Citation