Option Returns and Volatility Mispricing
38 Pages Posted: 14 Mar 2006
Date Written: February 2007
We study the cross-section of stock options returns and find an economically important source of mispricing in individual equity options. Sorting stocks based on the difference between historical realized volatility and market implied volatility, we find that a zero-cost trading strategy that is long (short) in straddles, with a large positive (negative) difference in these two volatility measures, produces an economically important and statistically significant average monthly return. The results are robust to different market conditions, to firm risk-characteristics, to various industry groupings, to options liquidity characteristics, and are not explained by linear factor models.
Keywords: option returns, implied volatility
JEL Classification: C21, G13, G14
Suggested Citation: Suggested Citation