The Joint Cross Section of Option and Stock Returns Predictability with Big Data and Machine Learning
67 Pages Posted:
Date Written: December 11, 2020
Using large set of stock and option specific characteristics, and machine learning, we first provide a comprehensive analysis of what drives expected delta hedged and delta-neutral straddle returns of equity options. In contrast to the previous literature, we find that option, rather than stock, characteristics are more important predictors of option returns. Second, option, rather than stock, characteristics are more important predictors of stock returns. In terms of variable importance for stock return predictability, most of machine learning methods we use outweigh option illiquidity. Consequently, stock long-short portfolio strategies formed conditioning on option illiquidity outperform in out-of-sample those of machine learning portfolios, which in turn outperform the market. The results point to positive option illiquidity premium in stock returns, as well as to overall competitive advantage of option market characteristics in identifying mispricing opportunities in the stock market.
Keywords: Machine learning, Option pricing, Stock return predictability
JEL Classification: G10, G12, G13, G14
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