A New Option Momentum: Compensation for Risk

Abstract

This paper introduces a novel momentum strategy in the options market based on the systematic component of option returns. Utilizing a latent factor model to decompose options returns, we demonstrate that the systematic component exhibits stronger momentum and subsumes the performance of conventional return-based momentum. With a six-month formation and one-month holding period, the strategy achieves an annualized Sharpe ratio of 2.23, compared to 1.08 for traditional momentum, and is highly profitable for various formation and holding periods. The superior performance is driven by time-varying risk compensation rather than investor biases, underscoring the economic rationale behind its success.

Keywords: Option, Momentum, Factor Risk, Limits to Arbitrage JEL classification: G11, G12, G14, G40

JEL Classification: G11, G12, G14, G40.