Option Strategies Based on Factor Sorts
December 22, 2015 - Equity Options
Do stock pricing factors predict option returns that are incremental to the factor premiums in underlying stock returns? In the December 2015 version of their paper entitled “Option Return Predictability”, Jie Cao, Bing Han, Qing Tong and Xintong Zhan examine whether 12 factors known to predict stock returns also predict delta-hedged (stock price-neutral) equity option returns. The 12 factors are: size, book-to-market, one-month reversal, momentum, accruals, asset growth, cash-to-assets, analyst earnings forecast dispersion, net stock issuance, idiosyncratic volatility, profitability and standardized unexpected earnings. For portfolio realism, they focus on monthly delta-neutral call writing. Specifically, for each factor each month, they:
- Rank stocks with dividend-unaffected options into tenths (deciles) based on the factor.
- Write an at-the-money call option with about 50 days to expiration and buy delta shares of each underlying stock (no daily hedge adjustments).
- Reform a portfolio that is long (short) the decile of delta-hedged written calls with the highest (lowest) expected factor returns.
They also look at a symmetric put strategy (buy a put and sell delta shares of the underlying stock). Using price/firm data for a broad (but groomed) sample of U.S. common stocks with options and daily closing bid and ask quotes for the specified options during January 1996 through December 2012 (a total of 5,179 underlying stocks), they find that: Keep Reading