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A factor model for option returns

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  • Büchner, Matthias
  • Kelly, Bryan

Abstract

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.

Suggested Citation

  • Büchner, Matthias & Kelly, Bryan, 2022. "A factor model for option returns," Journal of Financial Economics, Elsevier, vol. 143(3), pages 1140-1161.
    • Handle: RePEc:eee:jfinec:v:143:y:2022:i:3:p:1140-1161
    DOI: 10.1016/j.jfineco.2021.12.007
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    References listed on IDEAS

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    Cited by:

    1. Fengmin Xu & Jieao Ma, 2023. "Intelligent option portfolio model with perspective of shadow price and risk-free profit," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 9(1), pages 1-28, December.
    2. Langlois, Hugues, 2023. "What matters in a characteristic?," Journal of Financial Economics, Elsevier, vol. 149(1), pages 52-72.
    3. Sanjay K. Nawalkha & Xiaoyang Zhuo, 2022. "A Theory of Equivalent Expectation Measures for Contingent Claim Returns," Journal of Finance, American Finance Association, vol. 77(5), pages 2853-2906, October.
    4. Bartram, Söhnke & Djuranovik, Leslie & Garratt, Anthony, 2021. "Currency Anomalies," CEPR Discussion Papers 15653, C.E.P.R. Discussion Papers.
    5. Meng Tian & Liuren Wu & Zhiguo He, 2023. "Limits of Arbitrage and Primary Risk-Taking in Derivative Securities," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 13(3), pages 405-439.
    6. Li, Zhiyong & Wang, Haixu & Yu, Mei, 2023. "Beyond rocket science: A factor model for convertible bond returns," Economics Letters, Elsevier, vol. 233(C).
    7. Amit Goyal & Alessio Saretto, 2022. "Are Equity Option Returns Abnormal? IPCA Says No," Working Papers 2214, Federal Reserve Bank of Dallas.
    8. Wee Ling Tan & Stephen Roberts & Stefan Zohren, 2024. "Deep Learning for Options Trading: An End-To-End Approach," Papers 2407.21791, arXiv.org.
    9. Chen, Ying & Grith, Maria & Lai, Hannah L. H., 2023. "Neural Tangent Kernel in Implied Volatility Forecasting: A Nonlinear Functional Autoregression Approach," MPRA Paper 119022, University Library of Munich, Germany.

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    More about this item

    Keywords

    Option return; Factor model; Return predictability; IPCA;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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