A Factor Model for Option Returns

64 Pages Posted: 18 Oct 2021 Last revised: 16 Apr 2023

See all articles by Matthias Büchner

Matthias Büchner

University of Cambridge - Centre for Endowment Asset Management, Cambridge Judge Business School

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 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.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Suggested Citation

Büchner, Matthias and Kelly, Bryan T., A Factor Model for Option Returns (October 2021). NBER Working Paper No. w29369, Available at SSRN: https://ssrn.com/abstract=3944417 or http://dx.doi.org/10.2139/ssrn.3944417

Matthias Büchner (Contact Author)

University of Cambridge - Centre for Endowment Asset Management, Cambridge Judge Business School ( email )

United Kingdom

Bryan T. Kelly

Yale SOM ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Abstract Views
PlumX Metrics