Expected Option Returns

Abstract

This paper examines expected option returns in the context of mainstream asset pricing theory. Under mild assumptions, call options have expected returns which exceed those of their underlying security and which are increasing in their strike prices. Likewise, put options have expected returns which are below the risk-free rate and which are also increasing in their strike prices. Across a variety of time periods and return frequencies, S&P 500 and 100 index option returns strongly exhibit these characteristics. Under stronger assumptions, expected option returns are a linear function of option betas. Fama-MacBeth-style option return regressions produce risk premia close to the expected market return. However, the regression intercepts are significantly below zero. As a result, zero-beta, at-the-money straddle positions produce average losses of approximately three percent per week. Zero-beta straddles in other markets also lose money consistently. These findings suggest that some additional factor, such as systematic stochastic volatility, is priced in option returns.