Option Return Predictability

Abstract

We show the cross-section of equity option returns can be predicted by a variety of underlying stock characteristics and firm fundamentals, including idiosyncratic volatility, past stock returns, profitability, cash holding, new share issuance, and dispersion of analyst forecasts. Such predictability is not mechanically inherited from the stock market because these variables do not significantly predict stock returns in our sample, and our results hold for delta-hedged calls and puts in the same directions. We document new option trading strategies that are profitable even after transaction costs. These profits are robust across different market conditions and subsamples. They cannot be explained by existing stock market risk factors including market volatility risk or tail risk, or individual stock volatility risk premium, jump risk and option illiquidity. These systematic patterns in the relative valuation of options and the underlying stocks have important implications for option valuation and option market efficiency. * We thank Giovanni Barone-Adesi,Hendrik Bessembinder, Peter Carr, Tarun Chorida, Christopher Doffing, Nils Frieward, Ross Goran, Tarun Gupta, Christopher Hrdlicka, Jianfeng Hu, Robert Kosowski, Asriel Levin, Tse-Chun Lin, Roger Loh, Chayawat Ornthanalai, Lubos Pastor, Neil Pearson, Lin Peng, Geert Rouwenhorst, Christian Schlag, Raman Uppal, Pietro Veronesi, Christian Wagner, Jun Wang, Jason Wei, Hua Zhang, and seminar participants at Baruch College, Chinese University of Hong Kong, Cubist Systematic Strategies, Fudan University, Menta Capital, Morgan Stanley, Southwestern University of Finance and Economics, Singapore Management University, Two Sigma Investments, and Yinghua Fund Management for helpful discussions and useful suggestions. We have benefited from the comments of participants at the 4 Chicago Quantitative Alliance Asia Conference, the 3 Deutsche Bank Annual Global Quantitative Strategy Conference, the 4 OptionMetrics Research Conference and the 10 Annual Conference on Advances in the Analysis of Hedge Fund Strategies. The work described in this paper was fully supported by two grants from the Research Grant Council of the Hong Kong Special Administrative Region, China (Project No. CUHK 458212 and 14501115). All errors are our own.