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Option Return Predictability

Author

Listed:
  • Xintong (Eunice) Zhan
  • Bing Han
  • Jie Cao
  • Qing Tong

Abstract

We uncover new return predictability in the cross-section of delta-hedged equity options. Expected returns to writing delta-hedged calls are negatively correlated with stock price, profit margin, and firm profitability, but positively correlated with cash holding, cash flow variance, new shares issuance, total external financing, distress risk, and dispersion of analysts’ forecasts. Our option portfolio strategies have annual Sharpe ratio above two and remain profitable after transaction costs. Their profits can be explained by two option factors, while equity risk factors have no explanatory power. We find support for several economic channels at work, yet the option return predictability remains puzzling.

Suggested Citation

  • Xintong (Eunice) Zhan & Bing Han & Jie Cao & Qing Tong, 2022. "Option Return Predictability," The Review of Financial Studies, Society for Financial Studies, vol. 35(3), pages 1394-1442.
    • Handle: RePEc:oup:rfinst:v:35:y:2022:i:3:p:1394-1442.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhab067
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    Citations

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    Cited by:

    1. Siu Kai Choy & Jason Wei, 2022. "Option trading and returns versus the 52‐week high and low," The Financial Review, Eastern Finance Association, vol. 57(3), pages 691-726, August.
    2. Dörries, Julian & Korn, Olaf & Power, Gabriel J., 2023. "How should the long-term investor harvest variance risk premiums?," CFR Working Papers 23-06, University of Cologne, Centre for Financial Research (CFR).
    3. Kanne, Stefan & Korn, Olaf & Uhrig-Homburg, Marliese, 2023. "Stock illiquidity and option returns," Journal of Financial Markets, Elsevier, vol. 63(C).
    4. David Weinbaum & Andrew Fodor & Dmitriy Muravyev & Martijn Cremers, 2023. "Option Trading Activity, News Releases, and Stock Return Predictability," Management Science, INFORMS, vol. 69(8), pages 4810-4827, August.
    5. Martin Wallmeier, 2024. "Quality issues of implied volatilities of index and stock options in the OptionMetrics IvyDB database," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 44(5), pages 854-875, May.
    6. Siu Kai Choy & Jason Wei, 2023. "Investor Attention and Option Returns," Management Science, INFORMS, vol. 69(8), pages 4845-4863, August.
    7. Christian Keller & Michael C. Tseng, 2023. "Arrow-Debreu Meets Kyle: Price Discovery for Derivatives," Papers 2302.13426, arXiv.org, revised Jun 2024.
    8. Chen, Ding & Guo, Biao & Zhou, Guofu, 2023. "Firm fundamentals and the cross-section of implied volatility shapes," Journal of Financial Markets, Elsevier, vol. 63(C).

    More about this item

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • 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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