Characteristics and Expected Returns in

Individual Equity Options

Mete Karakaya

January 11, 2014
Abstract
I study excess returns from selling individual equity options that are leverage-adjusted
and delta-hedged. I nd that options with longer maturities have higher risk yet lower
average returns. I identify three new factorslevel, slope, and valuein option returns,
which together explain the cross-section of expected returns on option portfolios formed on
moneyness, maturity, and value. This three-factor model also helps explain expected returns
on option portfolios formed on twelve other characteristics. While the level premium appears
to compensate investors for market-wide volatility and jump shocks, market frictions help us
understand the slope and value premiums.
Keywords: expected option returns, option characteristics, option strategies, factor pricing
JEL codes: G11, G12, G13

I thank my advisors John Cochrane, Bryan Kelly, Ralph Koijen,

Lubos P astor and Harald Uhlig for their
invaluable guidance. I am grateful for comments, suggestions and support from Tobias Moskowitz, Pietro Veronesi,
George Constantinides, Andrea Frazzini, Lasse Pedersen, Dacheng Xiu, Emre Kocatulum, Can Bayir, Rui Mano,
Diogo Palhares, Burak Salto glu, Shri Santosh, Michael Baltasi and seminar participants at the University of Chicago
Booth School of Business, Central Bank of Turkey.

University of Chicago Department of Economics; Email: metekarakaya@uchicago.edu; phone: 312-213-8575;

Web: home.uchicago.edu/metekarakaya
I. Introduction
The market for individual equity options is huge but relatively understudied. I examine how
expected returns vary across individual equity options with a particular focus on moneyness,
maturity and option value. Specically, I study excess returns from selling individual equity
options that are leverage-adjusted monthly and delta-hedged daily.
Both delta-hedging and leverage adjustment are essential to my analysis. Delta-hedging strips
out most of the expected return variation that comes through stock returns. This allows me to
focus on the expected return variation that is unique to option markets. In the Black-Scholes
world, delta-hedged excess returns are zero on average, since agents can perfectly replicate options
by continuously trading the underlying stock and a risk-free bond. However, in the real world,
perfect replication fails due to discrete trading, transaction costs, and the presence of untradable
state variables such as stochastic volatility and jumps. As a result, delta-hedged excess returns
are not zero on average and they potentially compensate investors for risks, behavioral biases and
market frictions. Leverage adjustment is important because options with dierent moneyness and
maturity have vastly dierent degrees of leverage (e.g., Frazzini and Pedersen (2012)). Dierences
in leverage dominate dierences in option behavior. To account for leverage eect, I use the
sensitivity of an options return to the return of the underlying stock. This denition of leverage
measures the options return magnication relative to the return of the underlying stock. By
leverage-adjusting, I am able to detect new risk and return patterns that were previously obscured
by leverage.
I uncover a puzzling connection between option maturity, risk and expected return. I nd
that options with longer maturities have higher risk yet lower average returns. For example,
option portfolios with a long maturity have more volatile returns, higher market beta and lower
VIX beta compared to option portfolios with a short maturity. Moreover, they perform worse
during market-wide price and volatility jump episodes. According to popular belief, options earn
a premium as a compensation for market-wide volatility and jump shocks. Here, I argue that long
maturity options have higher volatility and jump risk yet lower average return. It is crucial to
adjust returns for leverage to see this maturity-risk pattern.
Earlier literature
1
nds that the expected return on selling options decreases by moneyness,
maturity and option value (the spread between historical volatility and the Black-Scholes implied
volatility).
2
Standard risk adjustment models, such as the CAPM, Fama and French (1993) three-
factor (FF3), and Carhart (1997) four-factor (FF4) or ve-factor (FF4 plus a volatility factor)
models, all fail to explain these patterns. Even more strikingly, these models all predict higher
1
Frazzini and Pedersen (2012); Goyal and Saretto (2009)
2
This spread is akin to the book-to-market ratio of a stock. For options, Black-Scholes implied volatility is a
measure of market value and realized volatility is a measure of fundamental value.
1
expected returns for long maturity options relative to short maturity ones.
I identify three new return-based factorslevel, slope, and valuewhich together explain the
cross-sectional variation in expected returns on option portfolios formed on moneyness, maturity
and option value. The level factor is the average return on selling at the money (ATM) option
portfolios. The slope factor is the average return on buying long maturity option portfolios and
selling short maturity ones. Lastly, the value factor is the average return on buying high value
option portfolios and selling low value ones. In the spirit of the Fama and French (1993) three-
factor model, I argue that we can describe the expected excess return of option portfolios based
on their sensitivity to these three factors. In particular, the expected excess return of portfolio i
can be described as,
E[R
e
i
] =
L
i
E[Level] +
S
i
E[Slope] +
V
i
E[V alue] (1)
R
e
i,t
=
i
+
L
i
Level
t
+
S
i
Slope
t
+
V
i
V alue
t
+
i,t
(2)
If the option three-factor model (OPT3: level, slope and value) in equation 1 and 2 holds, with

i
= 0 i, then the model is consistent with the idea that investors require a higher premium for
certain options because of their comovements with systematic factors.
The variation in the level betas capture the expected return variation along moneyness di-
rection, by gradually rising from in the money to out of the money option portfolios. Similarly,
the slope betas gradually decrease from short to long maturity option portfolios and as a result
explain the variation along maturity. Lastly, the value betas rise smoothly from high to low value
portfolios and explain the expected return variation among value portfolios.
To show the economic success of the option three-factor model, I compare its mean absolute
pricing errors (MAE =
1
N

||) against alternative models using thirty portfolios formed on

moneyness and maturity. The mean absolute average excess return (
1
N

|R
e
|) of the thirty
portfolios is 44 basis points (bps). This 44 bps can also be viewed as the MAE according to
Black-Scholes model (BS), since BS predicts that delta-hedged excess returns are on average equal
to zero.
3
CAPM, FF4 and FF5 produce MAE greater than 37 bps. On the other hand, OPT3
achieves MAE of only 15 bps. The results are qualitatively similar if we compare MAEs on
decile portfolios formed on value. BS MAE is 38 bps and the CAPM, FF4 and FF5 produce a
MAE of greater than 30 bps. In contrast OPT3 achieves MAE of less than 10 bps.
3
Black-Scholes model predicts zero expected delta-hedged excess return if hedging is done continuously. In
practice I rely on daily delta-hedging. According to my simulation results, daily delta-hedging introduce a bias in
the opposite direction. Bakshi and Kapadia (2003) get similar results. Therefore we should interpret 44 bps as
lower bound to the MAE of BS.
2
The option three-factor model (OPT3) is equally successful in sub-samples and it performs well
on several other sets of portfolios formed on twelve other characteristics. OPT3 is also economically
signicant. Annualized Sharpe ratios of the level, slope and value factors are 0.86, 3.22 and
2.61, respectively. Moreover, the tangency portfolio of the factors is magnifying the economic
signicance of OPT3, because the tangency portfolio has a Sharpe ratio of 5.15. Given the
economic signicance and empirical success of OPT3, it is economically interesting to understand
the level, slope and value factors.
I argue that the level factor is a risk factor, because it tends to crash during nancial and
liquidity crises such as Lehmans bankruptcy, the European sovereign crisis, the Asian nancial
crisis, the Russian default and the bankruptcy of WorldCom. Moreover, I nd strong evidence
that the premium on the level factor represents a compensation for market-wide volatility and
jump shocks. First of all, it is highly correlated with the innovations in VIX (-0.7), which can be
considered as a proxy for volatility shocks. The unconditional expected return on the level is 46
bps, while expected returns conditional on market-wide price-jumps and volatility-jumps are -200
and -82 bps, respectively. This evidence suggests that the level factor has a high exposure to jump
shocks. During severe bear markets, expected returns on the level factor rise dramatically to 126
bps. This is in line with the central intuition of macro asset pricing models with time-varying
expected returns. Expected returns are higher during recessions, since marginal value of wealth is
high at those times.
In contrast to the level factor, the empirical properties of the slope factor do not appear to
coincide with standard risk measures. It is highly sensitive to market-wide volatility and jump
shocks; however, the sign of sensitivity is positive. Volatility and jump shocks amplify the puzzle
by implying a negative premium for the slope factor. In order to explain the high premium on
the slope, we need to explain why short maturity options have higher expected returns than long
maturity options.
There are two key dierences between short and long maturity options, which aect the supply
and demand for options. The rst one is gamma (

2
OptionPrice
StockPrice
2
). It tells us the sensitivity of hedge
ratio (delta) to the movements in the underlying stock. It is more costly to hedge options with a
higher gamma and the hedge is less eective. When there is a large movement in the underlying
stock, selling options with higher gamma result in larger losses. Short maturity options have
substantially higher gamma than long maturity options. Even in the Black-Scholes world, the
average hedging cost of one-day to maturity options can be more than 200 times the hedging cost
of one-year to maturity options. In fact, what market makers fear most is having too much gamma
in their portfolio. With high negative total gamma, they can lose an arbitrarily large amount of
money, while the premium is limited. As a result, market makers are less willing to supply short
maturity options.
The second dierence is embedded leverage (the amount of market exposure per unit of com-
3
mitted capital). Short term options enable investors to take on higher leverage than long term
options. Frazzini and Pedersen (2012) argue that securities with high embedded leverage allevi-
ate investors leverage constraints. Therefore, investors are willing to pay more for assets that
enable them to increase their leverage. Because of high embedded leverage in short term options,
constrained investors demand short-term options more, driving up their prices.
The demand-based option pricing model of Garleanu, Pedersen, and Poteshman (2009) is re-
lated to both gamma and embedded leverage. They argue that risk-averse nancial intermediaries
require a higher premium on options with higher demand pressure, since they cannot hedge their
positions perfectly. Their theoretical model implies that demand pressure in one option contract
increases its price by an amount proportional to the variance of the unhedgeable part of the op-
tion. Because of gamma, the unhedgeable part is bigger for short term than long term options,
and because of embedded leverage, the demand pressure is bigger for short-term than long-term
options.
The value premium is dicult to explain as well. At the beginning of the nancial crises, the
value factor tends to lose, but once the turmoil begins, volatility spreads widen and the expected
returns on value rise dramatically. It is not possible to explain the value premium with market-
wide volatility or jump shocks. It has almost no correlation with contemporaneous innovations in
VIX and it tends to perform better during jump episodes. Average variance risk premia (VRP) is
considerably larger for low relative to high value portfolios. Sch urho and Ziegler (2011) develop
a model consistent with theories of nancial intermediation under capital constraints, in which
both systematic VRP and idiosyncratic VRP is priced. The interpretation of the value premium
as compensation for risk-averse nancial intermediaries is consistent with Sch urho and Ziegler
(2011) model.
4
If market frictions drive the slope and value premiums, then we should expect that these
premiums are related to funding liquidity conditions.
5
I nd that the premium on the slope and
value factors are higher when funding liquidity conditions are tight. The nding is consistent with
the idea that capital is required to exploit the slope and value premiums, and capital becomes
more costly when funding liquidity conditions are tight
I hypothesize that if market makers are averse to having too much gamma in their portfolios (as
I argue to explain maturity premium), then they will require a higher premium for selling options
on stocks in which they have high total gamma. I base this on the fact that their portfolios with a
higher total gamma will lose more when there is a large movement in the underlying stock price.
4
I also nd that low value option portfolios experience substantially higher growth in their total option market
capital then high value option portfolios in the portfolio formation month. This might be a sign for higher demand
pressure. If this is the case, then Garleanu, Pedersen, and Poteshman (2009) model can potentially explain the
premium on the value factor. I dene total option market capital as the sum of open interest times mid-price of
all options on the underlying stock.
5
Following Frazzini and Pedersen (2010), I proxy funding liquidity by TED spread.
4
To test this hypothesis, I construct a new characteristic open interest gamma, which is dened
as the sum of open interest times gamma of all options for a given underlying stock divided by
the market capital of that underlying stock. I sort options into decile portfolios by open interest
gamma and I nd that my hypothesis is correct. Excess returns and Sharpe ratios rise from low to
high in open interest gamma portfolios. The high minus low portfolio has a return with a Sharpe
ratio of 1.7 and t-statistics of 7.1.
Lastly, I explore two new option investment strategies: option carry and volatility reversals.
Carry is traditionally applied only to currencies; but Koijen, Moskowitz, Pedersen, and Vrugt
(2012) generalize this concept to other asset classes such as global equities, bonds, commodities
and index options. I nd that the carry trade is extremely successful in individual equity options,
with the high minus low carry portfolio achieving an annualized Sharpe ratio of 2.5, which is
greater than the premium on carry strategies in other asset classes. I dene volatility reversals as
the change in implied volatility over the past month for a given delta and maturity. A high minus
low volatility reversals portfolio generates considerable return with an annualized Sharpe ratio of
1.4. I show that the option three-factor model (OPT3) performs well at explaining the returns of
option carry and volatility reversals strategies.
I contribute to the large literature on empirical option pricing by showing that the option
three-factor model (OPT3) explains a substantial portion of average returns on option portfolios
formed on embedded leverage, stock size, stock and option illiquidity, stock short-term reversal,
volatility term structure (only for short maturity options), idiosyncratic volatility and variance risk
premia. However, OPT3 fails to explain returns on portfolios formed on volatility term structure in
long maturity options. All of these patterns are established by previous researchers. For instance,
Christoersen, Goyenko, Jacobs, and Karoui (2011) nd that illiquid options have higher expected
returns and options on illiquid stocks have lower expected returns for buyers. Vasquez (2012) nds
that option portfolios with a high slope of implied volatility have higher returns for buyers than the
ones with a lower slope of implied volatility term structure. Ang, Bali, and Cakici (2010) show that
call options on stocks with high returns over the past month (stock short-term reversal), display an
increasing implied volatility. Cao and Han (2012) nd that the return on buying options decreases
with an increase in idiosyncratic volatility of the underlying stock. Sch urho and Ziegler (2011)
show that variance risk is related to the cross-section of expected synthetic variance swap returns.
Di Pietro and Vainberg (2006) nd that rm characteristics such as size and book-to-market ratio
are related to expected returns on synthetic variance swaps.
The paper consists of seven sections. In Section II, I describe the data and explain the method-
ology. In Section III, I study patterns of expected option returns related to moneyness, maturity
and value. In Section IV, I propose an empirical pricing model and conduct asset pricing tests. In
Section V, I discuss economic interpretations for the pricing factors and option premia. I study
patterns of expected option returns related to other characteristics and conduct asset pricing tests
5
on them in Section VI. In Section VII, I provide concluding remarks.
A. Literature Review
This paper is directly related to the recently growing literature on expected option returns. We
can broadly classify these papers into three categories. The rst argues that option prices are
potentially aected by risk preferences. Coval and Shumway (2001) show that zero beta at the
money straddle returns are negative on average, which may suggest the presence of additional
priced factors such as systematic stochastic volatility. Bongaerts, De Jong, and Driessen (2011)
show that correlation risk is priced. Bakshi and Kapadia (2003) study delta-hedged option gains,
and argue that volatility risk is priced. The second category is about mispricings due to distorted
expectations (behavioral biases). Stein (1989), Poteshman (2001) and Goyal and Saretto (2009)
are examples. The nal category ties option prices to market frictions. Two examples of market
frictions are liquidity and embedded leverage (Christoersen, Goyenko, Jacobs, and Karoui (2011),
Frazzini and Pedersen (2012)). I contribute to this literature in several ways. First, I document
that carry and volatility reversals are related to expected option returns. While most of the
existing studies are done in a small sample with only at the money one-month maturity options,
I extend their results to dierent moneyness and maturity groups.
Option pricing theories are also relevant for this paper. Based on option pricing theories,
excess option returns should compensate investors for a variety of dierent risk premia, such as
stochastic volatility and price-jump and volatility-jump risk premium. Some notable examples in
this area are Bates (1996); Pan (2002); Broadie, Chernov, and Johannes (2007).
6
Most existing option pricing theories are designed for index options. A promising area of
research is to extend these models for individual equity options, which requires the daunting task
of identifying priced factors aecting option premia. A good starting point, followed by Elkamhi
and Ornthanalai (2010) and Christoersen, Fournier, and Jacobs (2013), is to incorporate market-
wide jump and volatility as priced factors. My results show that we need more than market-wide
volatility and jump factors to explain option premia.
Finally, this paper is also related to the growing literature studying term structure of risk and
risk premia across asset classes. Van Binsbergen, Brandt, and Koijen (2010) show that short-
term dividend strips on the S&P 500 index have higher returns and Sharpe ratios than long-term
dividend strips. Palhares (2012) nd that average returns decrease by maturity in CDS markets.
Duee (2011) show that Sharpe ratios decrease by maturity for nominal government bonds.
7
6
See also Heston (1993); Bates (2000); Carr and Wu (2004); Liu, Pan, and Wang (2005).
7
See also Van Binsbergen, Hueskes, Koijen, and Vrugt (2011); Lettau and Wachter (2007); Hansen, Heaton, and
Li (2008).
6
II. Methodology and Data
In this section, I rst describe my data sources and then provide a detailed explaination of the
lters that I use. After that I present the summary information on my nal sample, and from
there go on to explain holding period option excess return calculations that are delta-hedged daily
and leverage-adjusted monthly.
A. Data Sources
My primary data source is the OptionMetrics Ivy DB database, the industry standard for his-
torical option price information. The database was rst launched in 2002 and has since been
compiling the dealers end-of-day quotes directly from the U.S. exchanges. This data includes all
of the U.S. exchange-listed individual equity options from January 1996 to January 2013. All of
the options are American style. From the OptionMetrics option price les, I use the following
variables: the daily closing bid-ask quotes, open interest, trading volume, implied volatility and
the option Greeks (delta, gamma, vega, theta). Implied volatility and the Greeks are calculated
by using Optionmetrics proprietary algorithms based on Cox, Ross, and Rubinstein (1979) bino-
mial tree model, which accounts for discrete dividend payments and the early exercise possibility
of American options. As an input to their algorithms, they use the term structure of interest rates
derived from both the LIBOR rates and the settlement prices of the Chicago Mercantile Exchange
for Eurodollar futures. From the security price les, I use the following variables: close price,
return, volume, and shares outstanding. Lastly, I get the interpolated implied volatility, implied
strike price, delta, and days to maturity from the volatility surface les.
In addition, I use accounting data from Compustat to calculate the book value of companies.
I also get daily returns, volume, closing price and shares outstanding information from CRSP.
Because the Optionmetrics security price le starts in 1996, I use data from CRSP whenever
Optionmetrics data are not available. Lastly, I use high frequency stock trading data from TAQ
to estimate realized variances.
B. Filters and Final Sample
Generally, I use lters in the same manner as in previous studies, such as Goyal and Saretto (2009);
Frazzini and Pedersen (2012). I drop all observations where the bid is greater than the ask or
where the bid is equal to zero. Minimum tick size for options trading under $3 is equal to $0.05
and $0.10 for all others. I eliminate all observations where the bid-ask spread is smaller than
the minimum tick size and all observations that violate arbitrage bounds. I keep options with
standard settlements and expiration dates. I require positive open interest, non-missing delta,
implied volatility and spot price to keep the observations in the sample.
7
Following Frazzini and Pedersen (2012), I apply lters to eliminate options with very little time
value F-V, where F is an the price of option and V is intrinsic value ( payo you will receive if you
exercise, max(Spot-Strike,0) for call options and max(Strike-Spot,0) for put options). Specically,
I eliminate options where the time value expressed as a percentage of option price (F-V)/F is
less than 0.05. These options might get exercised early, which can aect the accuracy of their
return calculations. To control for outliers, I drop observations with embedded leverage at the top
and bottom 1% of the distribution for both calls and puts separately. The embedded leverage is
dened as the elasticity of option price with respect to the underlying stock price
P
P
/
S
S
.
Unlike previous studies, I require that observations have positive volume to keep them in the
sample. Closing price data might not be reliable, if the option contract has not been traded for a
while.
Lastly, I nd recording errors for 9 optionids (11928459, 33108873, 33108872, 44963448, 25242345,
45209832, 10758314, 46164533, 11932329) when searching for extreme observations. In each case
the option price jumped more than couple of thousand percent and reversed back a few days
later, when there was no signicant move in the underlying equity. I reported each case to the
Optionmetrics support desk.
For my nal sample, I use 11,008,246 option-months in total (6,066,370 call option-months and
4,941,876 put option-months). These observations come from 3,480,644 unique option contracts
(1,858,744 call and 1,621,900 put) and 7535 underlying stocks. On average there are 53,000 options
and 2500 underlying stocks per month.
Figure 1: Trading Volume
This gure displays aggregate trading volume in trillion dollars through years and allocation of trading
volume across 5 moneyness and 6 maturity groups. Panel A shows the results in market value, which is
volume times mid-price of an option, while Panel B shows the results in notional, which is estimated as
volume times closing price of underlying stock. Moneyness groups are DOTM (deep out of the money,
0 || < 0.20), OTM (out of the money, 0.20 || < 0.40), ATM (at the money, 0.40 || < 0.60 ) ITM
(in the money, 0.60 || < 0.80 ), DITM (deep in the money, 0.80 || < 1). Maturity groups are 1, 2,
3, 4 to 6, 7 to 12, greater than 12 months.
Panel A: Panel B:
1996 1998 2000 2002 2004 2006 2008 2010 2012
0
0.5
1
1.5
2
Option Trading Volume (Market Value)
V
o
l
u
m
e

(
i
n

t
r
i
l
l
i
o
n

d
o
l
l
a
r
s
)


0 10 20 30 40
DOTM
OTM
ATM
ITM
DITM
Percentage of total volume
M
o
n
e
y
n
e
s
s
|| 0.2
0.2 <|| 0.4
0.4 <|| 0.6
0.6 <|| 0.8
0.8 <||
0 10 20 30 40
1M
2M
3M
4:6M
7:12M
>12M
M
a
t
u
r
i
t
y
Percentage of total volume
All
Call
Put
1996 1998 2000 2002 2004 2006 2008 2010 2012
0
10
20
30
40
50
60
70
Option Trading Volume (Notional)
V
o
l
u
m
e

(
i
n

t
r
i
l
l
i
o
n

d
o
l
l
a
r
s
)


All
Call
Put
0 10 20 30 40
DOTM
OTM
ATM
ITM
DITM
Percentage of total volume
M
o
n
e
y
n
e
s
s
|| 0.2
0.2 <|| 0.4
0.4 <|| 0.6
0.6 <|| 0.8
0.8 <||
0 20 40 60
1M
2M
3M
4:6M
7:12M
>12M
M
a
t
u
r
i
t
y
Percentage of total volume
8
C. Institutional Details on Individual Equity Option Market
At the end of 1990s, the individual equity options market was relatively small, with aggregate
trading volume less than 400 billion dollars of market value and 10 trillion dollars of notional
value. In 2000, aggregate trading volume spiked up to above 500 billion dollars market value,
but after the dot-com bubble burst, trading volume shrank back to lower levels. Between 2004
and 2012, volume increased at a rapid pace. As a result, the individual equity option market has
turned into a giant market with trading volume of about 60 trillion dollars in notional and 1.5
trillion dollars in market value.
There is a considerable variation of trading volume across maturity and moneyness groups.
Short maturity options are more liquid than long maturity options, since more than 30% of
market value and 50% of notional value is in options with a one month maturity. In terms of
market value, at-the-money options have the biggest share, which is more than 35%. On the other
side, in notional amount, deep-out-of-the-money options have largest share.
D. Return Calculations (leverage-adjusted monthly, delta-hedged daily)
I work with holding period returns for approximately one month. The expiration date of individual
equity options is every month following the third Friday of a given month. I open the position
following the expiration date, usually a Monday, and hold it until the expiration date of the next
month while delta-hedging for the underlying stock daily. My delta-hedged return calculations are
exactly the same as in Frazzini and Pedersen (2012). The exact algorithm for the delta-hedged
return calculations is as follows: let V be the value of my portfolio, F the option price, S the
stock price, x the number of option contract holdings, the Black-Scholes delta, r
S
t
the stock
return and r
f
t
the risk free rate. The starting value of my portfolio V
0
is $1 and I buy x =
1
F
0
unit of option contracts, which I hold till the next expiration date. Every day, I gain or lose some
money from the change in option price x(F
t
F
t1
) , delta hedging x
t1
r
S
t
S and lastly from
the margin account r
f
t
(V
t1
xF
t1
+ x
t1
S
t1
). I iterate the value of my portfolio using this
algorithm from the beginning of holding period 0 to end of holding period T.
V
t
= V
t1
+ x(F
t
F
t1
)
. .
Options price appreciation
x
t1
r
S
t
S
t1
. .
P&L from delta hedge
+ r
f
t
(V
t1
xF
t1
+ x
t1
S
t1
)
. .
gain or loss from margin account
The delta-hedged return for option i is dened as the change in the value of portfolio during
the holding period.
r
i,[0,T]
= V
T
V
0
= V
T
1
I subtract the monthly risk free rate in order to work with excess returns.
9
r
e
[0,T]
= r
i,[0,T]

_
T

t=0
_
1 + r
f
t
_
1
_
Lastly, I adjust for leverage, which is dened as the elasticity of the option price with respect
to the stock price.
= |
F
F
S
S
| = |
S
F
F
S
| =
S
F
||
I scale delta-hedged excess returns with leverage in order to derive leverage-adjusted excess
returns.
R
e
i,[0,T]
=
1

r
e
i,[0,T]
In my analysis, I specically work with option market cap weighted portfolio returns, where
option market cap is dened as mid-price times open interest of the option contract. Let R
p,[0,T
be leverage-adjusted delta-hedged excess return of portfolio p.
R
p,[0,T]
=
N

i=1
v
i
R
e
i,[0,T]
In all of these calculations, I use a closing bid-ask midpoint for the option price; hence, I
implicitly assume no transaction costs. In my margin account calculations, I assume there is no
spread between lending and borrowing rates and that the initial margin requirement is zero.
E. Fama-French-Carhart Four-Factor Model Calculations
Rather than working with the standard monthly data from the beginning of a given month to the
next, my holding period is from the fourth week of each month to the fourth week of following
month. I calculate four factors for my holding period. I start with daily excess returns and add
back risk-free rates, then I compound over the holding period and subtract monthly risk-free rates.
My holding period return calculations for each factor are as follows:
_
Rm r
f
_
=
T

t=1
_
1 + Rm
d
t
_

T

t=1
_
1 + r
f
t
_
SMB
[0,T]
=
T

t=1
_
1 + SMB
d
t
+ r
f
t
_

T

t=1
_
1 + r
f
t
_
10
HML
[0,T]
=
T

t=1
_
1 + HML
d
t
+r
f
t
_

T

t=1
_
1 + r
f
t
_
WML
[0,T]
=
T

t=1
_
1 + WML
d
t
+ r
f
t
_

T

t=1
_
1 + r
f
t
_
where Rm
d
t
is daily market return, SMB
d
t
daily SMB return, HML
d
t
daily HML return, WML
d
t
daily WML return from Kenneth French data library.
F. Characteristic Calculations
In this subsection, I give detailed explanations for the fteen option-stock characteristics I used.
These characteristics are moneyness, maturity, value, option carry, variance risk premia, volatility
reversals, systematic volatility, idiosyncratic volatility, stock risk reversal, stock size, stock illiquid-
ity, option illiquidity, embedded leverage, slope of volatility term structure, open interest gamma.
As a precaution against recording errors and measurement errors, I keep a 1 day lag between the
date I estimate characteristics and the date I take position on an option. Moneyness and maturity
are the only two exceptions to this rule.
Moneyness : I dene the ve moneyness groups in terms of absolute value of delta || .
1) Deep out of the money (DOTM) 0 || < 0.20
2) Out of the money (OTM) 0.20 || < 0.40
3) At the money (ATM) 0.40 || < 0.60
4) In the money (ITM) 0.60 || < 0.80
5) Deep in the money (DITM) 0.80 || < 1
Maturity: I dene maturity as the number of holding periods (approximately 1 month) to
expiration. I form 6 maturity groups; 1, 2 , 3, 4 to 6, 7 to 12 and greater than 12 months (holding
periods) to expiration.
Option Value (Historical- Implied Volatility): I dene value as the dierence between historical
volatility and Black-Scholes implied volatility. I estimate historical volatility as the standard
deviation of daily realized volatility over the last 1 year. Goyal and Saretto (2009) show that
this variable is related to the ATM one month to maturity straddle returns, but they dont call
it value. I argue that this is a value-style investment strategy for options, because option value is
mimicking valuation ratios such as dividend-price, earning-price, book-to-market ratio for stocks.
We should interpret Black-Scholes implied volatility as a measure of market price and historical
realized volatility as some measure of fundamental value. In fact, realized volatility is like a
dividend for delta-hedged option traders, since they will be making money as they update their
hedge ratio. Option traders, who are long (short) options, will be making more (less) money with
11
the increase in realized volatility. This result is a direct consequence of positive (negative) gamma
of long (short) option positions and independent of the directions of stock price movements or the
nal outcome of the stock price. We should understand that the option has a low value when the
price (implied volatility) is high relative to historical volatility and high value if the price (implied
volatility) is low. For stocks, we compare market price to some intrinsic assessment of stock
(book value) to build value style investment strategies. For options, the same style of investment
corresponds to making an investment by comparing Black-Scholes implied volatility and historical
volatility. The essential philosophy of a value-style investment is just buy cheap assets and sell
expensive assets according to some measure.
Option Carry: Following Koijen, Moskowitz, Pedersen, and Vrugt (2012), I dene carry as the
return of an option contract if the underlying stock price and implied volatility term structure do
not change. Let F
t
(S
t
, K, T,
T
) be the price of an option contract (either call or put) at time
t, with maturity T, strike K and implied volatility
T
. Koijen, Moskowitz, Pedersen, and Vrugt
(2012) show that we can approximate the carry using the options rst time derivative theta ()
and rst volatility derivative vega . Let C
t
(S
t
, K, T,
T
) denote the options carry.
C
t
(S
t
, K, T,
T
) =

t
(S
t
, K, T,
T
)
t
(S
t
, K, T,
T
) (
T

T1
)
F
t
(S
t
, K, T,
T
)
F
t
, , and
T
are available from Optionmetrics, I interpolate
T1
from volatility surface
les. Lastly I adjust carry for leverage, since all my returns are leverage-adjusted. From now on,
I will always mean a leverage-adjusted carry when I talk about carry.
1

C
t
(S
t
, K, T,
T
)
Variance Risk Premia (VRP): Following Bollerslev, Tauchen, and Zhou (2009), I dene VRP
for each underlying stock as the dierence between model-free implied volatility or, in other words,
ex-ante risk-neutral expectation of the future return variation (IV
i,t
) over the [t, t + 1] time period
and the ex post realized return variation (RV
i,t
) over the [t 1, t] time period.
V RP
i,t
= IV
i,t
RV
i,t
My estimation procedure of IV
i,t
is as in Han and Zhou (2012).
IV
i,t
= 2
_

0
C
i
t
(t +T, K) /B(t, T) max(0, S
i
t
/B(t, T) K)
K
2
dK
where S
i
t
represents stock price of stock i at time t, T = 1/12. C
i
t
(t +T, K) stands for price of
call option on stock i, with strike K and time to maturity T. B(t,T) denotes price of zero coupon
12
bond that pays one dollar at time t+T. I numerically estimate IV
i,t
. At the end of the previous
holding period, I extract implied volatilities of 30 day call options from standardized Volatility
Surface les provided by OptionMetrics. I then transform these implied volatilities into option
prices using the Black-Scholes model.
To estimate RV
i,t
, I get TAQ intraday equity trading data spaced by 15 minute intervals. Let
p
i
j,t
denote log price of stock i at the end of j th 15-minute interval in holding period t and let N
t
denote number of trading days and n
t
number of 15-minute intervals in holding period t.
RV
i,t
=
252
N
t
nt

j=1
_
p
i
j,t
p
i
j1,t

2
Volatility Reversals: Let
t
(, T) denote Black-Scholes implied volatility at time t, which
belongs to an option with delta and time to maturity T. From the last holding period volatil-
ity surface le, I interpolate the implied volatility with the same delta and time to maturity

t1
(, T). Timing: if I am taking a position at the 4th Monday of month t,
t
(, T) is the
implied volatility of an option from the 3rd Thursday of month t,
t1
(, T) is interpolated from
the 3rd Thursday of month t-1. I dene volatility reversals as
t
(, T)
t1
(, T). This measure
gives us the change in implied volatility at a specic point on the volatility surface.
Systematic and Idiosyncratic Volatility: Following Cao and Han (2012), idiosyncratic volatility
IV OL
i,t
is dened as the standard deviation of residuals from the Fama French three-factor model,
which is estimated using daily data over the previous holding period. Systematic volatility is
dened as the
_
V OL
2
i,t
IV OL
2
i,t
, where V OL
i,t
is the standard deviation of daily returns of
stock i in period t.
Stock Short-Term Reversal : Jegadeesh (1990) dene short term reversal as the stock return
over the previous month. Since I dont work with regular monthly data, I calculate the stock
return over the previous holding period, which is about a month.
Stock Size: The rm size is a natural logarithm of the market value of equity, which is estimated
as the stock price times the number of shares outstanding.
Stock Illiquidity: Following Amihud (2002), I dene a stocks illiquidity as
|R
i,t
|
V
i,t
, where R
i,t
is
the month t return of stock i, and V
i,t
the total dollar volume of stock i in month t.
Option Illiquidity: I measure option illiquidity by the relative quoted spread. Previously
Christoersen, Goyenko, Jacobs, and Karoui (2011) use this measure.
bid ask
(bid + ask) /2
Embedded Leverage: Following Frazzini and Pedersen (2012), I dene embedded leverage as
the elasticity of the option price with respect to the stock price. In practice I use the delta from
13
the Black-Scholes model. I denote embedded leverage with .
=

F
F
S
S

S
F
F
S

=
S
F
||
Slope of Volatility Term Structure: I dene slope of volatility structure as the dierence between
implied volatility of at-the-money (|| = 0.5) options with 365 days to maturity and 30 days
to maturity. Since it is not possible to have 365 and 30 days to maturity, implied volatilities
interpolated numbers from Optionmetrics volatility surface les. This characteristics is dened
separately for both call and put options.
Open Interest Gamma: I dene open interest gamma as the sum of open interest times gamma
of all options for a given underlying stock divided by market capital of that underlying stock.
This characteristic measures the total gamma of all investors who short options on a given stock.
My implicit assumption is that this measure is correlated with total gamma of option market
makers on a given stock. Because of their risk aversion, option market makers will charge a higher
premium when they have high total gamma. I base this on the fact that their portfolios with
a higher total gamma will lose more when there is a large movement in the underlying stock
price. I scale by the market capital of the underlying stock, because I expect that there are more
option market makers with larger capital for options on large stocks. You should consider this
characteristic as a noisy measure of total gamma of option market makers. Note that options on
the same stock share the exact same number for this characteristic.
III. Moneyness, Maturity and Value Patterns
In this section, I summarize the descriptive statistics for the thirty portfolios formed on moneyness-
maturity and the decile portfolios formed on value. For every month, the standard expiration date
is the Saturday immediately following the 3rd Friday of the month. For the rst trading day
following the expiration date each month, I assign all available options into thirty groups based
on their moneyness and maturity. Note that each group includes both call and put options. The
moneyness and maturity groups as well as general denitions all follow Frazzini and Pedersen
(2012). I measure moneyness with the absolute value of delta || and assign options into 5
moneyness categories based on the range of ||: Deep out of the money 0 || < 0.20, out of
the money 0.20 || < 0.40, at the money 0.40 || < 0.60, in the money 0.60 || < 0.80,
deep in the money 0.80 || < 1. I measure maturity with holding periods up to expiration.
Holding periods are roughly one month in duration, so I will begin referring to holding periods
as months. I assign options into 6 maturity categories: 1, 2, 3, 4 to 6, 7 to 12, and greater than
12 months to expiration. To set the stage, the Figure 2 presents expected excess returns as well
14
as two standard deviation condence intervals across moneyness and maturity categories. You
can nd more detailed descriptive statistics across moneyness and maturity in the Table 1. I will
briey summarize the most important patterns.
Figure 2: Average Monthly Excess Returns Across Moneyness-Maturity
This gure displays average excess returns (basis points per month) from selling options across 5 moneyness
and 6 maturity groups. Red lines indicate two standard deviation condence intervals for average excess
returns. Moneyness groups are DOTM (deep out of the money, 0 || < 0.20), OTM (out of the money,
0.20 || < 0.40 ), ATM (at the money, 0.40 || < 0.60) ITM (in the money, 0.60 || < 0.80), DITM
(deep in the money, 0.80 || < 1). Maturity groups are 1, 2, 3, 4 to 6, 7 to 12, greater than 12 months.
DOTM OTM ATM ITM DITM
0
50
100
150
200
250
300
MoneynessMaturity
E
x
c
e
s
s

r
e
t
u
r
n

(
b
a
s
i
s

p
o
i
n
t
s

p
e
r

m
o
n
t
h
)


|| 0.2
0.2 <|| 0.4
0.4 <|| 0.6
0.6 <|| 0.8
0.8 <||
209
53
-6
175
46
4
132
28
17
94
25
10
46
11
5
Maturity Maturity Maturity Maturity Maturity
1 month
2 months
3 months
4:6 months
7:12 months
>12 months
The most puzzling pattern is related to maturity: expected returns decrease and several mea-
sures of risk rise by maturity. If we go back to Markowitz (1959), risk is dened as the standard
deviation of returns. If we consider the CAPM of Sharpe (1964), risk is market beta. If we
consider more modern option pricing theories, we need to think about volatility and jump risk.
Figure 3 presents several risk measures across the thirty moneyness-maturity portfolios. The
rst three panels report volatility of returns in basis points, CAPM and negative of VIX .
To estimate CAPM s, I regress excess returns on the thirty moneyness-maturity portfolios on
CRSP value-weighted market return over the full sample. Similarly, I regress excess returns on
the thirty moneyness-maturity portfolios on the change in VIX index to estimate VIX s. I use
holding-period excess returns and the change in VIX index in the regressions. Holding-periods
are about a month. You can observe a clear rise in volatility, CAPM and negative of VIX .
Note that VIX has a negative market price; hence, a rise in the negative of VIX implies rise
15
in risk. The rise in these risk measures with maturity is more pronounced in DOTM, OTM and
ATM option portfolios. Panel D report average excess returns across maturities during price jump
episodes. Price jump indicates months with at least one day with a jump in S&P 500 index, which
is dened as daily change in index less than -4%. You can see that long maturity options perform
worse during episodes of price jump. For example, in the full sample ATM option portfolio with
one month to maturity and three months to maturity have 132 bps and 28 bps of average excess
return per month, while during episodes of price jump, average return of option portfolios are
-62 and -252 bps, respectively. This evidence suggests that long maturity options are more prone
to crash risk. I also consider episodes of volatility jump and market distress. Volatility jump
indicates months with at least one day with a jump in the VIX index, which is dened as the daily
change in VIX greater than 4%. This denition of price jump and volatility jump closely follow
Constantinides, Jackwerth, and Savov (2011). I dene market distress as the months with con-
temporaneous monthly S&P 500 returns of less than -5%. In total there are 14 months with price
jumps, 39 months with volatility jumps and 25 months with contemporaneous market returns less
than -5%. The average excess return pattern on the thirty moneyness-maturity portfolios during
volatility jump episodes and market distress are similar to the average excess return pattern during
price jumps, which is reported in Figure 3 panel D.
Previous researchers did not notice a maturity-risk pattern, because they focus on Index options
and study leverage-unadjusted option returns. If we look at the same risk measures for leverage-
unadjusted returns of S&P 500 index options, patterns are completely reversed. Short maturity
options appear to be more risky than long maturity options. For leverage-unadjusted returns of
individual equity options, patterns are reversed or not monotonic. This suggests that for a long
time, we were blinded by the leverage of short maturity options.
The second pattern concerns moneyness, where the average return and volatility from selling
OTM options is much higher than the ITM options for short term options (up to 3 months).
For long term options, the volatility persists; OTM options are more volatile, though there is
no pattern in average returns. Table 1 also presents the t-statistics and Sharpe ratios of excess
returns from selling options. The Sharpe ratios and t-statistics decrease by maturity. In fact, only
short term options (up to 3 months) have statistically signicant excess returns. The OTM, ATM,
and ITM option portfolios have higher Sharpe ratios and t-statistics than the DOTM and DITM
options. Usually skewness and kurtosis are concerns for option returns and so Table 1 also reports
those statistics. Most of the skewness estimates are greater than -1.2 and kurtosis estimates are
less than 10. Though there are a few exceptions, the DOTM options have a skewness of up to
-2.3 and DITM long maturity options have a kurtosis of 20. Broadie, Chernov, and Johannes
(2009) report skewness and kurtosis of OTM standard put option returns all the way up to 5.5
and 34; Constantinides, Jackwerth, and Savov (2011) report even more extreme estimates for
standard option returns ( skewness greater than 10 and kurtosis greater than 100). Compared to
16
standard option returns, leverage-adjusted and delta-hedged returns have much lower skewness
and kurtosis. The return distribution is obviously not normal, but they are not signicantly worse
than stock portfolios. For instance, Frazzini and Pedersen (2012) report the skewness and kurtosis
of a momentum portfolio -3.04 and 26.67; for Fama French HML 1.83 and 15.54 for the 1926-2010
sample.
Figure 3: Risk Across Moneyness-Maturity
The gure displaysaverage monthly volatility, capm , negative of VIX and negative of excess returns
during price-jump episodesacross moneyness-maturity portfolios. s are estimated using holding period
returns over the full sample. Blue lines indicate two standard deviation condence intervals for s. The
full sample covers 204 months from January 1996 to January 2013. Price jump (nobs=14) indicates months
with at least one day with a jump in S&P 500 index, which is dened as daily change in index less than -4%.
See Table 1 for the details of moneyness and maturity groups.
DOTM OTM ATM ITM DITM
0
100
200
300
400
500
600
700
MoneynessMaturity

i
n
b
a
s
i
s
p
o
i
n
t
s
Panel (A) Volatility


|| 0.2
0.2 <|| 0.4
0.4 <|| 0.6
0.6 <|| 0.8
0.8 <||
1 month
2 months
3 months
4:6 months
7:12 months
>12 months
DOTM OTM ATM ITM DITM
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
MoneynessMaturity
C
A
P
M

Panel (B) CAPM Beta

1 month
2 months
3 months
4:6 months
7:12 months
>12 months
DOTM OTM ATM ITM DITM
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
MoneynessMaturity
-
V
I
X

Panel (C) - VIX Beta

1 month
2 months
3 months
4:6 months
7:12 months
>12 months
DOTM OTM ATM ITM DITM
0
100
200
300
400
500
600
700
MoneynessMaturity
-
E
x
c
e
s
s
r
e
t
u
r
n
(
b
a
s
i
s
p
o
i
n
t
s
p
e
r
m
o
n
t
h
)
Panel (D) - Average Excess Returns During Price-Jumps


|| 0.2 0.2 <|| 0.4 0.4 <|| 0.6 0.6 <|| 0.8 0.8 <|| || 0.2 0.2 <|| 0.4 0.4 <|| 0.6 0.6 <|| 0.8 0.8 <||
1 month
2 months
3 months
4:6 months
7:12 months
>12 months
17
Table 1: Summary Statistics of Portfolios formed on Moneyness and Maturity
This table reports summary statistics of portfolios formed on moneyness and maturity. For each month,
the Saturday following the 3rd Friday of the month is standard expiration date. Each month, at the rst
trading day following the expiration date, I assign options into thirty portfolios based on ve moneyness
(absolute value of delta) and six maturity (months to expiration) groups. Moneyness groups are DOTM
(deep out of the money, 0 || < 0.20), OTM (out of the money, 0.20 || < 0.40), ATM (at the money,
0.40 || < 0.60), ITM (in the money, 0.60 || < 0.80), DITM (deep in the money, 0.80 || < 1).
Maturity groups are 1, 2, 3, 4 to 6, 7 to 12, greater than 12 months (holding periods). I keep the option
positions till the next expiration date. For each option in the portfolio, I calculate excess returns that
are delta-hedged daily and leverage-adjusted monthly. I calculate portfolio excess returns by taking option
market capital weighted average return of each option in a given portfolio, where option market capital is
open interest times option price. I report means, standard deviations, t-statistics, annualized Sharpe ratios,
skewness and kurtosis of monthly (percentage) portfolio excess returns (delta-hedged, leverage adjusted).
Table also presents delta, gamma, vega of options in a given portfolio. Option Greeks and implied volatilities
are calculated by OptionMetrics based on Cox, Ross, and Rubinstein (1979) model. Lastly table presents
percentage of total trading volume in market value and in notional. The sample covers 204 months from
January 1996 to January 2013.
Moneyness Maturity
1 2 3 4:6 7:12 >12 1 2 3 4:6 7:12 >12
Mean Standard Deviation
DOTM 2.10 0.97 0.53 0.15 0.08 -0.06 3.44 4.64 4.54 4.92 4.91 6.27
OTM 1.76 0.96 0.47 0.25 0.20 0.04 2.37 2.74 2.96 2.95 3.08 3.47
ATM 1.32 0.71 0.28 0.15 0.12 0.17 1.73 1.87 1.94 2.01 2.16 2.29
ITM 0.94 0.51 0.26 0.14 0.10 0.10 1.10 1.42 1.19 1.31 1.62 1.48
DITM 0.46 0.24 0.12 0.01 0.03 0.05 0.98 1.02 0.96 0.84 1.15 1.16
T-statistics Sharpe Ratio
DOTM 8.71 3.00 1.68 0.43 0.22 -0.14 2.11 0.73 0.41 0.11 0.05 -0.03
OTM 10.61 5.01 2.25 1.22 0.95 0.17 2.57 1.22 0.55 0.30 0.23 0.04
ATM 10.92 5.44 2.06 1.09 0.78 1.07 2.65 1.32 0.50 0.26 0.19 0.26
ITM 12.27 5.13 3.07 1.48 0.85 0.99 2.98 1.24 0.74 0.36 0.21 0.24
DITM 6.80 3.31 1.79 0.21 0.38 0.65 1.65 0.80 0.43 0.05 0.09 0.16
Skewness Kurtosis
DOTM -1.51 -2.28 -2.29 -1.97 -1.42 -1.46 7.80 11.68 11.63 9.33 6.62 7.75
OTM -1.35 -1.00 -1.50 -1.36 -0.90 -1.46 7.05 5.71 8.68 7.76 7.90 9.74
ATM -0.83 -0.88 -1.03 -1.24 -0.89 -1.60 5.52 7.52 7.18 8.53 7.98 11.46
ITM 0.42 1.30 -1.01 -0.76 -0.12 -1.57 5.55 12.44 6.25 7.10 14.15 10.90
DITM 0.97 0.58 -0.60 -1.70 -1.57 -0.46 8.46 11.32 8.04 9.66 14.35 20.26
abs(Delta) Gamma
DOTM 0.12 0.11 0.12 0.12 0.12 0.12 0.04 0.03 0.03 0.03 0.02 0.01
OTM 0.30 0.30 0.30 0.30 0.30 0.30 0.10 0.08 0.06 0.05 0.04 0.03
ATM 0.50 0.50 0.50 0.50 0.50 0.50 0.12 0.09 0.08 0.06 0.05 0.03
ITM 0.70 0.70 0.70 0.70 0.69 0.69 0.10 0.08 0.07 0.06 0.04 0.02
DITM 0.85 0.86 0.86 0.86 0.86 0.87 0.06 0.05 0.04 0.03 0.02 0.01
Vega Embedded Leverage
DOTM 2.62 3.51 4.36 5.96 8.90 14.00 14.61 11.48 9.69 7.75 6.24 3.88
OTM 4.07 5.67 6.88 8.87 13.14 22.60 12.65 9.55 7.95 6.29 5.20 3.36
ATM 4.62 6.47 7.85 10.07 14.46 25.38 10.57 7.79 6.47 5.19 4.40 3.03
ITM 4.05 5.65 6.93 8.96 13.24 23.27 8.33 6.12 5.12 4.20 3.59 2.61
DITM 2.84 3.90 4.76 6.06 8.92 15.06 6.84 5.04 4.25 3.52 2.94 2.22
18
% of Trading Volume (Market Value) % of Trading Volume (Notional)
DOTM 2.25 1.00 0.55 0.93 0.70 0.61 21.89 5.68 2.36 2.74 1.69 0.92
OTM 7.15 3.39 2.04 3.75 2.87 2.28 14.37 5.00 2.35 3.26 1.99 0.96
ATM 12.87 7.04 4.80 5.62 4.22 3.36 13.39 5.74 3.22 2.55 1.58 0.84
ITM 7.17 2.62 1.55 2.74 1.94 2.17 3.94 1.08 0.48 0.63 0.39 0.31
DITM 6.32 2.62 1.72 2.47 1.94 1.29 1.47 0.39 0.21 0.28 0.17 0.10
Table 2: Summary Statistics of Value Portfolios
This table reports summary statistics for portfolios sorted on value. I dene value as the dierence between
one-year historical realized volatility (calculated using daily stock returns) and Black-Scholes implied volatil-
ity. For each month, the Saturday following the 3rd Friday of the month is standard expiration date. Each
month, at the rst trading day following the expiration date, I assign options into decile portfolios based
on their value. I keep the option positions until the next expiration date. For each option in the portfolio,
I calculate excess returns that are delta-hedged daily and leverage-adjusted monthly. I calculate portfolio
excess returns by taking value weighted average return of each option in a given portfolio, where values
are option market value (open interest times mid price). I report means, standard deviations, t-statistics,
annualized Sharpe ratios, skewness and kurtosis of portfolio excess returns. Table also presents average
implied volatilities, delta, gamma, vega, theta, days to maturity of options in a given portfolio. Option
Greeks and implied volatilities are calculated by OptionMetrics based on Cox, Ross, and Rubinstein (1979)
model. Lastly, the table presents average VRP (variance risk premia) and lag growth in total option market
capital of options on a given portfolios. I dene total option market capital as the sum of open interest
times mid-price of all options on the underlying stock. The sample covers 204 months from January 1996 to
January 2013.
High Low
1 2 3 4 5 6 7 8 9 10 10-1
Mean -0.11 0.06 0.06 0.12 0.18 0.25 0.30 0.41 0.62 1.74 1.85
Standard Deviation 2.50 1.97 1.83 1.65 1.61 1.57 1.61 1.74 1.87 2.89 2.24
T-statistics -0.66 0.46 0.46 1.08 1.56 2.30 2.69 3.35 4.72 8.57 11.78
Sharpe Ratio -0.16 0.11 0.11 0.26 0.38 0.56 0.65 0.81 1.15 2.08 2.86
Skewness -1.18 -1.41 -1.25 -1.14 -1.06 -1.48 -1.31 -0.93 -0.85 -0.35 1.07
Kurtosis 6.81 8.95 8.47 7.86 10.00 11.86 11.53 9.20 9.59 6.68 6.48
Value 0.25 0.11 0.07 0.04 0.02 -0.00 -0.02 -0.05 -0.08 -0.23 -0.47
Implied Vol 0.56 0.46 0.42 0.40 0.38 0.38 0.39 0.42 0.47 0.71 0.15
abs(Delta) 0.59 0.59 0.59 0.59 0.60 0.61 0.62 0.62 0.63 0.59 -0.00
Gamma 0.04 0.04 0.04 0.04 0.03 0.03 0.03 0.03 0.03 0.04 -0.00
Vega 13.24 16.17 16.74 16.70 17.85 18.77 19.20 19.65 20.31 10.91 -2.33
Theta -8.00 -7.70 -7.05 -6.96 -7.12 -7.53 -8.22 -9.35 -10.51 -11.37 -3.36
Days To Maturity 213 212 207 205 203 200 195 187 173 143 -70
VRP -0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.02 0.06 0.06
Option Market-Capital 0.08 0.06 0.05 0.05 0.05 0.05 0.06 0.07 0.10 0.20 0.12
Table 1 also reports the trading volume in market value and notional of each portfolio as a
percentage of total trading volume. Market value is calculated as open interest times option price
and notional value is calculated as open interest times closing price of underlying stock. More
than 97% of the trading volume in notional derives from DOTM, OTM, ATM, and ITM options;
therefore, we might consider giving less weight to the results from the DITM option portfolios.
19
Trading volume is also concentrated in short maturity options with less than three months to
maturity. In fact, more than 80% of trading volume in notional value and 60% of trading volume
in market value is concentrated in options with less than three months to maturity.
Table 2 displays on the summary statistics for the portfolios based on value. Following Goyal
and Saretto (2009), I dene value as the dierence between the 1 year historical volatility of
underlying stock returns and the Black-Scholes implied volatility. The returns on selling low value
(expensive) options is much higher than high value (cheap) options. The average returns decrease
smoothly from 1.74% (t-statistics: 8.57) to -0.11% (t-statistics: -0.66), but there is no clear pattern
to the standard deviation of returns. In the lowest decile, the implied volatility is 23% higher than
the realized volatility; in the highest decile, it is 25% lower than realized volatility. However, there
is no economically and statistically signicant return in buying high value portfolios.
Goyal and Saretto (2009) report that this characteristic is associated with the expected return
of ATM options with one month to maturity from the 1996 to 2006 sample. In my analysis, I
extend the sample from 1996 to 2013, and I use all moneyness and maturity categories. I nd
this pattern very pervasive. In unreported results, I build portfolios within each moneyness and
maturity group; high minus low value portfolios generate a high expected return spread within
almost all groups.
I also consider alternative decile portfolio formations. Initially, I build decile portfolios within
each maturity moneyness group, and then I aggregate them by taking their weighted average,
where the weights are option market capital (mid price times open interest). For instance, I build
a lowest decile portfolio within each of the 30 maturity moneyness group, then I take the weighted
average of all the lowest decile portfolios within each group, and call the resulting portfolio as
the lowest decile of all options. This way I can keep the moneyness and maturity of the decile
portfolios relatively stable.
The expected return pattern is still very smooth and strong (low-minus-high Sharpe ratio: 2.3)
in the moneyness-maturity controlled decile portfolios. The pattern is very robust in various sub-
samples too. For example, I started the sub-sample from the end of Goyal and Saretto (2009)s
sample, 2007:2013 a low-minus-high portfolio generates a Sharpe ratio of greater than 2 with
reasonable skewness kurtosis estimates. Regarding stock return anomalies, patterns often vanish
once they are known; value strategy with regard to options seems to persist well after Goyal and
Saretto (2009)s paper. In fact nowadays this strategy is very famous in the industry, and some
nancial intermediary rms report this for their clients (e.g., Fidelity).
IV. Pricing
In the rst part of this section, I test the Fama-French-Carhart four-factor model on the thirty
portfolios formed on moneyness-maturity. In the second, I propose a new empirical pricing model
20
and then test it on the moneyness-maturity portfolios and value portfolios.
A. Asset Pricing Test of The Fama-French-Carhart Four-Factor Model
In the previous section, we saw various patterns of expected returns. The question then becomes,
can these be explained with usual stock market risk factors? For this reason, I test the Fama-
French-Carhart four-factor (FF4) model on moneyness-maturity portfolios. I start with daily
factor returns and calculate holding period returns. Details are in the methodology section.
My testing methodology is as follows: I run time-series regressions of excess returns of option
portfolios on FF4 factors; I estimate coecients with OLS. If FF4 describes the expected returns,
then the regression intercepts should be close to 0. To test this, I calculate the F-statistics
of Gibbons, Ross, and Shanken (1989) (GRS). Under the null hypothesis of 0 pricing errors, I
bootstrap 10,000 samples. I run the same regressions and estimate GRS statistics for each sample.
The t-statistics of coecients and the p-value of GRS statistics are then calculated from the
bootstrap procedure.
Table 3 presents the s, slope coecients, and t-statistics, adjusted r-squares from multiple
time-series regressions, as well as the GRS statistics and its p-value. The FF4 model is strongly
rejected by the data. The GRS statistic is 16.43 and the null hypothesis that s (pricing errors)
are jointly 0, is rejected at a 0.01 signicance level. More importantly, the average portfolio returns
and s are almost the same, and so the model has very little explanatory power for a cross section
of option returns. For instance, the average return of an ATM 1m option is 132 basis points; the
model could explain only 11 basis points of this return. The mean of the absolute excess returns
for the thirty portfolios is 44 basis points, the FF4 can reduce it only to 37 basis points, not very
much.
Market betas are signicant and rise from ITM to OTM and from short maturity to long
maturity options. This implies that market betas predict a higher return for long maturity options
than short maturity options. R-squares are around 20 to 40%, hence the model fails to explain
the variance of returns as well as means.
I also consider extending FF4 with a volatility factor. To achieve this, I estimate the option
market capital weighted portfolio excess return (delta-hedged, leverage-adjusted) of options (ATM,
1-month to maturity) on SP 500. I do this separately for call and put options, then take their
average.
I test FF5 (FF4 plus a volatility factor) on the thirty moneyness-maturity portfolios. Adding
the volatility factor does not help. Actually MAE of FF5 is four basis points greater than MAE
of FF4, because the volatility factor predicts a higher premium for long maturity options. You
can see excess returns, FF5 predicted returns and s in Figure 4. Adding the liquidity factor as
in Pastor and Stambaugh (2003) does not help to price these portfolio returns either.
21
Table 3: Asset Pricing Test of FF4 on Moneyness-Maturity Portfolios
This table reports the results of multiple regressions and asset pricing tests. I test the Fama-French-Carhart
four-factor model on excess returns (delta-hedged, leverage-adjusted) of the thirty portfolios formed on
moneyness-maturity. There are ve moneyness (absolute value of delta) and six maturity (months to expi-
ration) groups. Moneyness groups are DOTM (deep out of the money, 0 || < 0.20), OTM (out of the
money, 0.20 || < 0.40), ATM (at the money, 0.40 || < 0.60), ITM (in the money, 0.60 || < 0.80),
DITM (deep in the money, 0.80 || < 1). Maturity groups are 1, 2, 3, 4 to 6, 7 to 12, greater than 12
months (holding periods). I report s, slope coecients, t-statistics and R-squares. GRS is the joint test
of all pricing errors. I run OLS with 10,000 bootstrap simulations under the null hypothesis of zero pricing
errors to estimate t-statistics and p-values.
1
,
2
,
3
,
4
are coecients of excess market return, SMB
(small minus big), HML (high minus low), WML (momentum); respectively. To save space, I dont report
coecient of WML. The data on pricing factors are available from Kenneth French data library. I convert
daily returns to holding period returns (details are explained in methodology section). The sample covers
204 months from January 1996 to January 2013.
R
e
i,j,t
=
i,j
+
1
i,j
(Rm
t
Rf
t
) +
2
i,j
SMB
t
+
3
i,j
HML
t
+
4
i,j
WML
t
+
i,j,t
i {DOTM, OTM, ATM, ITM, DITM} j {1M, 2M, 3M, 4 : 6M, 7 : 12M, > 12M}
Moneyness Maturity
1 2 3 4:6 7:12 >12 1 2 3 4:6 7:12 >12
t()
DOTM 1.90 0.66 0.15 -0.24 -0.32 -0.63 8.72 2.39 0.58 -0.90 -1.13 -1.86
OTM 1.57 0.77 0.22 -0.00 -0.05 -0.28 10.63 4.63 1.35 -0.01 -0.32 -1.58
ATM 1.21 0.59 0.12 0.00 -0.03 -0.04 10.64 5.13 1.06 0.02 -0.24 -0.33
ITM 0.89 0.42 0.17 0.05 0.00 -0.02 12.31 4.72 2.48 0.70 0.02 -0.26
DITM 0.47 0.18 0.06 -0.02 -0.05 -0.00 6.81 2.63 1.05 -0.35 -0.68 -0.07

1
t(
1
)
DOTM 0.24 0.39 0.42 0.51 0.48 0.68 5.27 6.93 7.76 9.23 8.05 9.75
OTM 0.19 0.22 0.29 0.30 0.31 0.37 6.05 6.50 8.44 8.97 8.92 10.02
ATM 0.09 0.14 0.19 0.19 0.20 0.24 3.95 6.01 8.40 7.71 8.02 9.88
ITM 0.06 0.11 0.12 0.11 0.12 0.13 3.79 5.81 8.23 7.23 5.84 7.60
DITM -0.00 0.05 0.07 0.04 0.06 0.06 -0.14 3.12 5.28 3.26 4.24 3.95

2
t(
2
)
DOTM 0.02 0.01 0.13 0.08 0.15 0.29 0.28 0.09 1.72 0.99 1.82 2.90
OTM 0.11 0.06 0.08 0.10 0.15 0.22 2.46 1.33 1.69 2.12 3.06 4.17
ATM 0.07 0.07 0.09 0.10 0.10 0.17 1.96 2.02 2.90 2.83 2.75 4.96
ITM 0.04 0.05 0.03 0.06 0.11 0.13 1.85 1.71 1.44 2.79 3.79 5.31
DITM 0.03 0.05 0.07 0.05 0.12 0.11 1.36 2.31 3.61 2.79 5.56 5.01

3
t(
3
)
DOTM 0.26 0.40 0.36 0.37 0.32 0.41 3.66 4.49 4.18 4.25 3.46 3.68
OTM 0.16 0.21 0.22 0.22 0.22 0.26 3.23 3.84 4.06 4.11 3.96 4.43
ATM 0.13 0.14 0.12 0.13 0.12 0.16 3.40 3.73 3.39 3.39 3.10 4.00
ITM 0.06 0.08 0.07 0.07 0.06 0.07 2.36 2.76 2.93 2.86 1.80 2.53
DITM 0.00 0.04 0.02 0.03 0.04 0.02 0.11 1.79 0.98 1.66 1.64 0.74
Adj R-square GRS (p-val)
DOTM 0.22 0.32 0.34 0.42 0.34 0.43 16.43 (0.0000)
OTM 0.23 0.28 0.37 0.40 0.41 0.47
ATM 0.14 0.26 0.36 0.35 0.37 0.47
ITM 0.13 0.22 0.34 0.34 0.26 0.35
DITM 0.02 0.07 0.20 0.13 0.20 0.21
22
Figure 4: Asset Pricing Test of FF5 on Moneyness-Maturity Portfolios
The top panel presents average excess returns and predicted returns by the FF5 (FF4 plus a volatility factor)
across moneyness and maturity. Red bars are average excess returns, green bars are predicted values. The
bottom panel presents alphas as red bars and their two standard deviation condence intervals as blue lines
across moneyness and maturity groups. See Table 3 for details of moneyness-maturity groups.
DOTM OTM ATM ITM DITM
0
50
100
150
200
250
E
x
c
e
s
s

r
e
t
u
r
n

(
b
a
s
i
s

p
o
i
n
t
s

p
e
r

m
o
n
t
h
)
|| 0.2
0.2 <|| 0.4
0.4 <|| 0.6
0.6 <|| 0.8
0.8 <||
1M 3M 12M 1M 3M 12M 1M 3M 12M 1M 3M 12M 1M 3M 12M
DOTM OTM ATM ITM DITM
100
0
100
200
MoneynessMaturity
A
l
p
h
a
B. Empirical Option Pricing Model with Three Factors
In the spirit of the Fama-French three-factor model, I propose applying an empirical pricing model,
which I name the option three-factor model. In the rst subsection, I explain how I construct
factors. In the second subsection, I test this model on the thirty moneyness-maturity portfolios
and the decile value portfolios.
1. Pricing Factors
I construct pricing factors as linear combinations of the excess returns of the moneyness-maturity
and value portfolios. Note that the thirty moneyness-maturity portfolios are formed on ve mon-
eyness categories based on the range of ||: Deep out of the money (DOTM) 0 || < 0.20, out
of the money (OTM) 0.20 || < 0.40, at the money (ATM) 0.40 || < 0.60, in the money
(ITM) 0.60 || < 0.80, deep in the money (DITM) 0.80 || < 1 and, 6 maturity categories:
1, 2, 3, 4 to 6, 7 to 12, and greater than 12 months to expiration. The decile value portfolios
are formed on value, which is dened as the dierence between historical volatility and Black-
Scholes implied volatility. Portfolio (expensive) 1 consists of options with high value (cheap),
while portfolio 10 consists of low value options.
23
Level Factor : I dene level as the average return from selling at-the-money (ATM) option
portfolios. R
e
i,j,t
denotes excess return of option portfolio with moneyness category i and maturity
category j at time t.
Level
t
=
1
6

j
R
e
i,j,t
i{ATM} , j{1M, 2M, 3M, 4 : 6M, 7 : 12M, > 12M}
Slope Factor: I dene slope as the average return from selling option portfolios with 1-2 months
to maturity minus average return on selling option portfolios with 4 to 6 months to maturity.
Slope
t
=
1
12

i
1

j
1
R
e
i,j,t

1
6

i
2

j
2
R
e
i,j,t
i
1
{DOTM, OTM, ATM, ITM, DITM}, j
1
{1M, 2M}
i
2
{DOTM, OTM, ATM, ITM, DITM}, j
2
{4 : 6M}
Value Factor : I dene VAL as the average return from selling the lowest three value decile
portfolios minus the highest three value decile portfolios. R
e
i,t
denotes excess return on the ith
decile value portfolio at time t, where 10th decile portfolio consists of options with low value.
V AL
t
=
10

i=8
R
e
i,t

3

i=1
R
e
i,t
2. Asset Pricing Test of The Option Three-Factor Model on the Moneyness-Maturity
Portfolios
In this part, I test the option three-factor model on the excess returns on the thirty portfolios
formed on moneyness-maturity and argue that equation 1 is a good description of those expected
returns. To show the progress made by option factor models, I begin by estimating the mean
absolute pricing errors (MAE) of the thirty moneynes-maturity portfolios
1
30

j
|
i,j
| under 7
dierent pricing models. These models are BS (Black-Scholes), FF4 (Fama-French-Carhart four-
factor model), PCA2-PCA5 ( the models with the rst 2 and 5 principal components of the thirty
moneyness-maturity portfolios), OPT2 ( the option two-factor model with level and slope), and
OPT3 ( the option three-factor model with level, slope and value). The BS is the benchmark
case, since BS implies that these returns should be on average equal to 0. The Figure 5 shows the
success of the option factor models. The MAE for the benchmark BS is about 44 basis points.
The CAPM and FF4 models reduce it to only 36 basis points. The PCA based models are not
24
successful either. The option factor models, however, reduce the MAE to 13-15 basis points.Table
4 reports the results of the following time series regressions.
R
e
i,j,t
=
i,j
+
L
i,j
Level
t
+
s
i,j
Slope
t
+
v
i,j
V alue
t
+
i,j,t
i{DOTM, OTM, ATM, ITM, DITM} j{1M, 2M, 3M, 4 : 6M, 7 : 12M, > 12M}
Figure 5: Average || : Moneyness-Maturity Portfolios
The gure presents average || under dierent models. BS refers to Black-Scholes, FF4 refers to the Fama-
French-Carhart four-factor model. PCA2 and PCA5 refers to pricing model with rst 2 and 5 principal
component of the thirty moneyness-maturity portfolios. OPT2 refers to the option two-factor model (level
and slope), OPT3 the option three-factor model (level, slope and value).
BS CAPM FF4 FF5 PCA2 PCA5 OPT2 OPT3
0
5
10
15
20
25
30
35
40
45
M
A
E

B
a
s
i
s

P
o
i
n
t
s
I estimate coecients using OLS. I calculate the GRS statistics as they do in Gibbons, Ross,
and Shanken (1989) to test the joint signicance of pricing errors. Under the null hypothesis of
zero pricing errors, I bootstrap 10,000 samples from the tted regression residuals. At each sample
I run the same regressions and estimate GRS statistics. The t-statistics of the coecients and
the p-value of the GRS statistics are all calculated from bootstrap procedure. If the option three-
factor model describes the expected excess returns of moneyness-maturity portfolios, then the s
should be close to zero. The model seems to do well on average, with mean absolute s (MAE)
of about 15 basis points, but the model still leaves large intercepts for some of the portfolios. In
particular, it tends to leave intercepts far from zero for DOTM options. For example, the DOTM
option portfolios with 2 and 3 months to maturity have intercepts of -80 and -65 basis points.
Excluding the DOTM option portfolios, the MAE of the volatility surface portfolios is about 9
basis points. I should also note that the DOTM and DITM option portfolios are relatively less
liquid than the OTM, ATM and ITM option porfolios which cover most of the trading volume in
market value. The ITM option portfolio with 1 month to maturity and the ATM option portfolios
with 3 months to maturity and greater than 12 months to maturity leave about 18-19 basis point
absolute intercepts. This is not much, but statistically signicant. However, this might be sample
specic: the statistical signicance of the s do not seem to be robust across sub-samples. The
option three-factor explains a considerable portion of the realized volatility of excess returns. The
average R-squares for the ATM and OTM option portfolios are high, about 88%, it decreases to
75% for the ITM and DOTM options, it is lowest for the DITM options at 38%.
25
Table 4: Asset Pricing Test of OPT3 on Moneyness-Maturity Portfolios
This table reports the results of multiple regressions and asset pricing tests. I test the option three-
factor model (OPT3) on excess returns (delta-hedged, leverage-adjusted) on the thirty portfolios formed
on moneyness-maturity. There are ve moneyness (absolute value of delta) and six maturity (months to
expiration) groups. Moneyness groups are DOTM (deep out of the money, 0 || < 0.20), OTM (out of the
money, 0.20 || < 0.40), ATM (at the money, 0.40 || < 0.60), ITM (in the money, 0.60 || < 0.80),
DITM (deep in the money, 0.80 || < 1). Maturity groups are 1, 2, 3, 4 to 6, 7 to 12, greater than
12 months (holding periods). I report s, slope coecients, t-statistics and R-squares. GRS is the joint
test of all pricing errors. I run OLS with 10,000 bootstrap simulations under the null hypothesis of zero
pricing errors to estimate t-statistics and p-values.
L
,
S
,
V
are factor sensitivities of the level, slope,
value factors respectively. The sample covers 204 months from January 1996 to January 2013.
R
e
i,j,t
=
i,j
+
L
i,j
Level
t
+
s
i,j
Slope
t
+
v
i,j
V alue
t
+
i,j,t
i {DOTM, OTM, ATM, ITM, DITM} j {1M, 2M, 3M, 4 : 6M, 7 : 12M, > 12M}
Moneyness Maturity
1 2 3 4:6 7:12 >12 1 2 3 4:6 7:12 >12
t()
DOTM -0.13 -0.80 -0.65 -0.27 0.01 -0.31 -0.52 -2.27 -2.16 -1.08 0.04 -0.97
OTM 0.14 0.03 -0.27 -0.01 0.14 0.02 1.03 0.18 -1.88 -0.07 1.12 0.15
ATM 0.06 0.03 -0.18 -0.04 -0.06 0.19 0.62 0.33 -2.36 -0.87 -0.77 2.15
ITM 0.19 -0.17 -0.06 -0.02 0.04 0.13 2.31 -1.47 -0.79 -0.34 0.38 1.83
DITM 0.06 -0.18 -0.07 -0.05 0.00 0.12 0.58 -1.77 -0.78 -0.71 0.03 1.08

L
t(
L
)
DOTM 1.83 2.21 2.13 2.19 2.03 2.54 18.51 16.52 18.43 22.90 18.24 21.01
OTM 1.40 1.47 1.49 1.39 1.35 1.46 27.21 27.31 27.34 39.72 27.99 30.23
ATM 1.04 1.01 1.00 0.97 1.02 0.96 27.44 29.09 34.54 53.20 34.51 28.73
ITM 0.59 0.65 0.59 0.62 0.67 0.61 19.04 15.15 21.99 29.64 17.31 22.00
DITM 0.32 0.40 0.37 0.29 0.33 0.30 7.89 10.31 11.12 10.17 7.67 6.88

S
t(
S
)
DOTM 1.50 0.73 0.11 -0.78 -0.95 -1.65 7.54 2.68 0.46 -4.03 -4.25 -6.74
OTM 1.15 0.40 0.03 -0.50 -0.67 -0.98 11.04 3.67 0.26 -7.00 -6.80 -10.11
ATM 0.99 0.29 -0.02 -0.29 -0.32 -0.65 12.89 4.02 -0.30 -7.83 -5.32 -9.69
ITM 0.48 0.23 0.05 -0.18 -0.30 -0.35 7.74 2.64 0.93 -4.17 -3.84 -6.23
DITM 0.28 0.28 0.04 -0.09 -0.18 -0.26 3.36 3.53 0.58 -1.54 -2.02 -2.98

V
t(
V
)
DOTM 0.12 0.14 0.12 0.09 -0.05 0.54 0.96 0.84 0.86 0.74 -0.40 3.64
OTM -0.01 -0.09 0.03 0.05 0.02 0.21 -0.18 -1.39 0.41 1.14 0.33 3.56
ATM -0.07 -0.03 0.02 -0.00 -0.01 0.11 -1.58 -0.80 0.47 -0.12 -0.40 2.65
ITM 0.08 0.20 -0.00 0.02 0.01 -0.01 2.06 3.74 -0.05 0.92 0.21 -0.34
DITM 0.02 -0.01 -0.02 0.01 0.03 0.02 0.36 -0.18 -0.49 0.26 0.53 0.38
Adj R-square GRS (p-val)
DOTM 0.64 0.63 0.72 0.84 0.78 0.83 1.95 (0.0027)
OTM 0.79 0.83 0.85 0.94 0.89 0.92
ATM 0.79 0.84 0.90 0.96 0.92 0.91
ITM 0.65 0.60 0.78 0.89 0.75 0.84
DITM 0.23 0.36 0.47 0.49 0.38 0.38
26
Figure 6: Asset Pricing Test of OPT3 on Moneyness-Maturity Portfolios
The top panel presents average excess returns and predicted returns by the option three-factor model (OPT3)
across moneyness and maturity. Red bars are average excess returns, green bars are predicted values. The
bottom panel presents alphas as red bars and their two standard deviation condence intervals as blue lines
across moneyness and maturity groups. See Table 4 for details of moneyness-maturity groups.
DOTM OTM ATM ITM DITM
0
50
100
150
200
250
E
x
c
e
s
s

r
e
t
u
r
n

(
b
a
s
i
s

p
o
i
n
t
s

p
e
r

m
o
n
t
h
)
|| 0.2
0.2 <|| 0.4
0.4 <|| 0.6
0.6 <|| 0.8
0.8 <||
1M 3M 12M 1M 3M 12M 1M 3M 12M 1M 3M 12M 1M 3M 12M
DOTM OTM ATM ITM DITM
150
100
50
0
50
MoneynessMaturity
A
l
p
h
a
Despite the fact that the option three-factors s are substantially less than the absolute excess
returns, the F-test of Gibbons, Ross, and Shanken (1989) still rejects the null hypothesis that all
s are jointly zero. Furthermore, I added a couple of new factors that do not solve the problem.
I interpret this with the existence of small non-systematic priced factors. In the next subsection, I
will diagnose the rejection by applying a principal component analysis. I test linear factor models
consisting of principal components of moneyness-maturity portfolios. I nd that we need rst
15 principal components to not to reject a model in the data. One interpretation of these small
priced factors: they might be reecting the dierence of expected return between portfolios due to
liquidity. Another interpretation is that these factors are unreal and sample specic. The option
three-factor model (OPT3) is actually not rejected in recent sample (January 2005 to January
2013). In the following sections I will show that OPT3 performs even better for the other sets of
portfolios I considered.
Another interesting thing about these regressions concerns the pattern of factor s. The
coecients of level
L
does not change much across dierent maturities.
M
is about 2 for DOTM
27
option portfolios, gradually decreases to 1.5 and 1 for OTM and ATM portfolios and lastly it
decreases to 0.6 and 0.3 for ITM and DITM option portfolios.
L
varies with moneyness, because
the volatility of DOTM options is much higher than DITM options. If we adjust the returns with
volatility,
L
would be more or less constant. In contrast, coecients of slope factor, monotonically
varies over the maturity dimension, and B
S
is positive for short maturity options and negative for
long maturity options. The magnitude of positiveness and negativeness is higher for DOTM
options since they are more volatile. The value factor does not have any explanatory power for
the moneyness-maturity portfolios. I include it only to show that it does not make the results
substantially worse. It does not explain these portfolios, because it is not correlated with them. We
will however nd it crucial in explaining the decile value portfolios as well as other characteristic-
based option portfolios.
3. Diagnosing Rejection : Principal Component Analysis (PCA)
In this subsection, I will answer two important questions:
1. Why do we rely on ad-hoc factor construction rather than principal component analysis?
2. We rejected the option three-factor model, but how many factors do we need to accept a
linear factor pricing model?
To answer these questions, I extract the principal components of the thirty moneyness-maturity
portfolios. Figure 7 presents the results. The rst gure displays the cumulative R-square ex-
plained by the rst n principal components. There is a strong factor structure: the rst principal
component explains more than 83% of the variation of returns, with the rst two component num-
bers going up to 88%. I form empirical pricing models using the rst n principal components from
n=1 to n=16, and then I test the principal component models on the thirty moneyness-maturity
portfolios. The second and third gure of the Figure 7 show the p(GRS) (p-value of GRS statistics)
and MAE (mean absolute pricing error) from multiple asset pricing tests.The last gure displays
the mean of principal components (PC) with two standard deviation condence intervals. Mean
of PC is not statistically dierent than zero, if the condence interval passes from zero.
The results are surprising. To explain the thirty portfolios, we need fteen principal compo-
nents not to reject the model. It seems like there are many small priced factors. The PCA method
gives us the model of variances, but usually model variance is also a good model of mean. At
least this was the case in the previous applications of the PCA method on stocks, government
bonds, currencies, CDS and corporate bonds.
8
Equity options seem to be an exception. One of
the main reasons for this result is the relationship of mean and volatility with maturity. Long
maturity option portfolio excess returns are more volatile, but have smaller means. The principal
8
See Nozawa (2012),Palhares (2012),Lustig, Roussanov, and Verdelhan (2011).
28
components explain mainly unpriced variations in long maturity options. In fact, we can see from
Figure 7 that there are factors that are not statistically dierent than zero, yet they explain a
big part of return variation. This is why I rely on an ad-hoc method rather than a PCA one to
construct factors. The PCA models need 5-6 factors and 13-14 factors in order to achieve MAE
and GRS statistics similar to the option three-factor model (15 basis points, 1.95).
Figure 7: Principal Component Analysis
This gure display the results of principal component analysis and asset pricing tests on the thirty moneyness-
maturity portfolios. X-axis refers to the number of principal components. The rst gure displays the
cumulative R
2
explained by rst n principal components. P-value of the GRS statistics is denoted by p(GRS).
MAE refers to the mean absolute pricing errors. The second and third gure displays p(GRS) and MAE
from testing pricing model with rst n principal components on the thirty moneyness-maturity portfolios.
The last gure displays mean of principal components (PC) with two standard deviation condence intervals.
The sample covers 204 months from January 1996 to January 2013.
0 5 10 15
80
85
90
95
100
Cumulative R
2
0 5 10 15
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
p(GRS)
0 5 10 15
0
10
20
30
40
MAE
0 5 10 15
1
0
1
2
3
4
E[PC]
OPT3
OPT2
4. Value
In this part, I argue that equation 1 is a good specication for the decile value portfolios expected
excess returns. To show this, I test the option three-factor model on decile value portfolio excess
returns using time-series regressions. In particular, I estimate the following equation for the
January 1996 to January 2013 sample period.
R
e
i,t
=
i
+
L
i
Level
t
+
S
i
Slope
t
+
V
i
V alue
t
+
i,t
i{1, 2, ..., 10}
29
The methodology of the asset pricing test is the same as before. I bootstrap 10,000 samples
from the tted regression residuals. At each sample, I run the same regressions and estimate GRS
statistics. The t-statistics of coecients and the p-value of GRS statistics are calculated from the
bootstrap procedure. Table 5 presents the details of the asset pricing tests. If equation 1 is a good
description of the expected returns, then the regression intercepts should be close to zero. The
F-test of Gibbons, Ross, and Shanken (1989) fails to reject the option three-factor model with
1.15 GRS statistics and a corresponding 0.24 p-value. Hence, the intercepts from the time-series
regressions are not jointly statistically dierent than zero. Most of the s are small and their
t-statistics are not statistically signicant as well. Portfolio 10, however, is statistically signicant
but the model is still a clear improvement. This is because the average excess return of Portfolio
1 is 175 basis points, while the from the three-factor model is only 32 basis points. Most of the
explanatory power comes from the value factor, whose coecient monotonically varies from 1.12
for low value portfolios to -0.55 for high value portfolios. The coecients of level and slope do
not have any clear pattern, but if I exclude any one of them then the model is economically and
statistically rejected. The option three-factor seems to be a good model for the realized volatility
of value portfolios as well, the average R-square is about 90%.
Table 5: Asset Pricing Test of OPT3 on the Decile Value Portfolios
This table reports results of multiple regressions and asset pricing tests. I test the option three-factor model
on excess returns (delta hedged, leverage adjusted) of the decile portfolios formed on value (one year historical
realized volatility minus Black-Scholes implied volatility). I report s, slope coecients, t-statistics and R-
squares. GRS is the joint test of all pricing errors. I run OLS with 10,000 bootstrap simulations under the
null hypothesis of zero pricing errors to estimate t-statistics and p-value.
L
,
S
,
V
are slope coecients
of the level, slope, value factors respectively. R
e
i,t
is excess return on portfolio i at time t. The sample covers
204 months from January 1996 to January 2013.
R
e
i,t
=
i
+
L
i
Level
t
+
s
i
Slope
t
+
v
i
V alue
t
+
i,t
i {1, 2, ..., 10}
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
Value High Low
E[R
e
] -0.11 0.06 0.06 0.12 0.18 0.25 0.30 0.41 0.62 1.72 1.84
0.20 0.17 -0.09 -0.04 -0.04 -0.03 -0.02 -0.05 0.01 0.32 0.11
t() (1.74) (2.32) (-1.28) (-0.57) (-0.63) (-0.48) (-0.34) (-0.71) (0.13) (2.43) (0.98) 1.15 (0.24)

L
1.07 0.90 0.89 0.80 0.77 0.74 0.75 0.80 0.84 1.23 0.15
t(
L
) (24.32) (32.52) (32.11) (32.67) (33.13) (28.94) (29.44) (30.82) (34.82) (24.68) (3.44)

S
-0.35 -0.27 -0.12 -0.17 -0.20 -0.17 -0.20 -0.25 -0.28 -0.21 0.14
t(
S
) (-4.01) (-4.79) (-2.22) (-3.38) (-4.43) (-3.33) (-3.92) (-4.86) (-5.76) (-2.13) (1.57)

V
-0.55 -0.32 -0.17 -0.07 0.04 0.10 0.16 0.34 0.51 1.12 1.67
t(
V
) (-10.33) (-9.36) (-4.90) (-2.31) (1.42) (3.15) (5.20) (10.64) (17.36) (18.49) (30.63)
R
2
0.87 0.92 0.90 0.91 0.91 0.88 0.89 0.90 0.93 0.87 0.83
30
V. Understanding Factors and Option Premia
In the previous sections, I rst show that expected option returns are related to moneyness,
maturity and option value (the spread between historical volatility and the Black-Scholes implied
volatility), then I show that three systematic return-based factors (level, slope, value) explain the
cross-sectional variation on expected option returns related to moneyness, maturity and value. In
this section, I investigate the economics behind these factors. It is important to understand why
these factors have high risk prices and why they have information about the cross-section of option
premia.
To set the stage, Figure 8 plots the time-series of the cumulative sum of excess log returns for
all three pricing factors. The gure give us the rst clue about the economic meanings of pricing
factors. For example, there is a clear pattern related to the level factor in which it tends to crash
during nancial and liquidity crises such as Lehmans bankruptcy, the European sovereign crisis,
the Asian nancial crisis, the Russian default and the bankruptcy of WorldCom. The slope factor
is just puzzling, because it does not seem to suer during crises. Meanwhile, the value factor shows
it own interesting pattern, in which it loses slightly at the beginning of a nancial crisis, but once
the crisis starts, this factor tends to rise sharply. This pattern is most likely a consequence of the
rise in volatility spreads during the crisis.
Figure 8: Cumulative Factor Returns and Mean-Variance Frontier
The left panel displays log cumulative return of the level, slope, value factors. The right panel displays
tangency portfolio and mean-variance frontier of the level, slope and value factors. SR stands for annualized
Sharpe ratio.
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
(
l
o
g
)

C
u
m
u
l
a
t
i
v
e

R
e
t
u
r
n
s


Asian
financial
crisis
Russian
default
crisis
WorldCom
bankruptcy
Lehman
bankruptcy
European
sovereign
crisis
Asian
financial
crisis
Russian
default
crisis
WorldCom
bankruptcy
Lehman
bankruptcy
European
sovereign
crisis
Asian
financial
crisis
Russian
default
crisis
WorldCom
bankruptcy
Lehman
bankruptcy
European
sovereign
crisis
Level
Slope
Value
0 20 40 60 80 100 120 140 160 180 200 220
0
10
20
30
40
50
60
70
80
90
100
110
Standard Deviation
E
x
c
e
s
s

R
e
t
u
r
n

(
b
a
s
i
s

p
o
i
n
t
s

p
e
r

m
o
n
t
h
)
Level (SR=0.86)
Tangency (SR=5.15)
Value (SR=2.61)
Slope (SR=3.22)
Table 6 presents the summary statistics of these pricing factors. The level factor has a mean 46
basis point monthly return, 184 basis point volatility and 0.86 annualized Sharpe ratio. The level
factor is very similar to the rst principal component of the thirty moneyness-maturity portfolios
with a correlation coecient of 0.96. The slope factor has a mean 86 basis point monthly return,
31
92 basis point volatility and 3.22 annualized Sharpe ratio. Lastly, the value factor has a mean
91 basis point monthly return, 121 basis point volatility and 2.61 annualized Sharpe ratio. The
correlation structure between pricing factors are surprising. The level and slope factors have high
negative (-0.61) correlation with each other and they are essentially uncorrelated with the value
factor. As a result, there is enormous diversication benets in combining these three strategies.
Table 6 also presents summary statistics of tangency portfolio of the level, slope and value factors.
The tangency portfolio has an annualized Sharpe ratio of 5.15. From Figure 8, we can see that
the tangency portfolio does not suer from crashes.
The evidence strongly indicates that the level factor behaves as a risk premium and is a
compensation for market-wide volatility and jump shocks, in particular the fact that the level
factor is highly sensitive to the contemporaneous innovations in VIX. Their correlation coecient
is more than -0.7, which is not surprising since the level factor is basically the return on selling
volatility. Note that VIX has a negative market risk price since high volatility corresponds to the
bad states of nature. We can also see from Table 6 that the level factor has a high correlation,
around 0.6, with excess market returns.
To develop this argument, I evaluate the performance of the level factor under dierent states
of nature. To do this, I consider several sub-samples, which include months in which there are
market-wide price jumps, volatility jumps and months without any jumps. I use jump denitions
similar to the ones used in Constantinides, Jackwerth, and Savov (2011). Price jump is dened
as the daily change in S&P 500 index of less than -4%, and volatility jump is dened as the daily
change in VIX index greater than 4%. If there is more than one day with a price (volatility)
jump day in a given month, I call that month price (volatility) jump. I also consider periods
with NBER recessions, market distress (months with market return less than -5% or -10%), severe
bear markets (market return over the past twelve months less than -25%), and high-low volatility
(months with top-bottom 30% of VIX distribution over the sample period, exact thresholds are
around 25% and 16%).
I nd that the level factor is extremely sensitive to the episodes of price and volatility jumps.
Average returns during price jumps (14 months) are -200 basis points with a -1.7 Sharpe ratio; on
the other hand, average returns are 64 basis points with a 1.6 Sharpe ratio during months without
price jumps (190 months). We see a similar eect of volatility jumps. Average returns during
volatility jumps (39 months) are -82 basis points with -0.9 Sharpe ratio; average returns go up to
76 basis point with a 2.1 Sharpe ratio during periods without any volatility jumps (165 months).
I nd that average return of the level factor is not sensitive to NBER recessions and expansions,
but the volatility is highly sensitive. Volatility of the level during recessions is more than twice its
volatility during expansions. During the severe bear markets (market return over the past twelve
months less than -25%), average returns rise dramatically to 126 basis points. This is in line with
the central intuition of macro asset pricing models with time-varying expected returns. Expected
32
returns are higher during recessions, since marginal value of wealth is high at those times. The
level factor is also very sensitive to the market distress. The people who invest in the level lose
197 basis points and 485 basis points during the months with monthly market return less than 5%
(25 months) and 10% (7 months).
Table 6: Summary Statistics of Factors
This table reports summary statistics for ten factors. The level factor is the average return on selling at
the money (ATM) option portfolios; the slope factor is the average return on buying long maturity option
portfolios and selling short maturity ones; lastly, the value factor is the average return on buying high value
option portfolios and selling low value ones. Tang is the tangency portfolio of the level, slope and value
factors. P1 and P2 are rst and second principal components of the thirty moneyness-maturity portfolios.
Rm-Rf, SMB, HML, WML are factors of the Fama-French-Carhart four-factor model (excess market return,
small minus big, high minus low, momentum). Lastly dVIX refers to monthly (holding period) change in
VIX. The sample covers 204 months from January 1996 to January 2013.
Level Slope Value Tang P1 P2 Rm-Rf SMB HML WML dVIX
Mean 0.46 0.86 0.91 0.77 1.99 2.15 0.54 0.31 0.18 0.56 0.08
St.Dev. 1.84 0.92 1.21 0.52 14.00 3.39 5.47 3.50 3.14 5.67 6.10
Sharpe Ratio 0.86 3.22 2.61 5.15 0.49 2.20 0.34 0.31 0.20 0.34 0.04
T-statistics 3.56 13.28 10.78 21.25 2.03 9.07 1.40 1.26 0.81 1.41 0.18
Skewness -1.21 0.93 1.11 0.07 -1.56 0.29 -0.98 0.34 -0.29 -0.70 2.08
Kurtosis 8.69 6.58 6.03 5.33 8.27 8.84 5.92 5.46 6.84 8.02 11.82
Correlation Coecients
Level 1.00 -0.61 -0.03 0.17 0.96 -0.08 0.57 0.08 0.36 -0.24 -0.70
Slope 1.00 0.16 0.63 -0.62 0.54 -0.52 -0.05 -0.20 0.27 0.57
Value 1.00 0.51 -0.00 0.05 -0.01 0.00 0.03 -0.00 -0.05
Tang 1.00 0.13 0.54 -0.09 0.02 0.10 0.09 0.01
P1 1.00 0.00 0.61 0.01 0.39 -0.19 -0.73
P2 1.00 -0.14 -0.28 0.10 0.23 0.17
Unlike the level factor, I nd it extremely challenging to explain the premium on the slope
factor, which is essentially buying long maturity options and selling short maturity options. Based
on modern option pricing theories, the slope premium is potentially a compensation for market-
wide volatility, price-jump and volatility-jump risk. Table 6 reports the correlation coecient
between the slope factor and innovations in VIX. Indeed, the slope factor is moderately sensitive
to the innovations on VIX since they have correlation of a 0.57. However the correlation has the
wrong sign. Correlation with VIX implies a negative premium for the slope factor, not a positive
one. The slope factor also has a negative market beta, which implies a negative premium.
Traditionally, investors view short maturity options as being more sensitive to the jumps than
long maturity options, since short maturity options are more levered positions. It is tempting to
think that jumps can explain the slope premium. There is one problem with this interpretation:
since I adjust for the leverage when forming positions, short maturity options are not necessarily
more sensitive to the jumps. According to Figure 8, we dont see any negative jump for the
33
slope factor. Moreover, we can observe mild positive jumps during Lehmans bankruptcy and the
European sovereign crisis. Evaluating the performance of the slope factor under sub-samples shed
further light on the slope-jump link. The average return on the slope factor is 163 basis points
during a price-jump period (14 months) as opposed to 80 basis points during period without any
price jump (190 months). The pattern is similar for volatility jumps, with 130 basis points versus
75 basis points. From Table 6, we also see that the slope factor performs better during NBER
recessions (116 basis points) than expansions (80 basis points). The slope factor does extremely
well during market distress. The people who invest in the slope factor earn 190 basis points and
295 basis points during the months with monthly market return of less than 5% (25 months) and
10% (7 months). These results are puzzling, since the slope factor behaves as an insurance, yet
it has a positive premium. It is true that the slope factor is highly sensitive to jumps, but jump
risk implies a negative premium for the slope. As a result, we need to think beyond the standard
market-wide volatility jump risk interpretation in order to understand the slope premium.
Indeed, the slope premium puzzle and the maturity-risk puzzle are two sides of the same coin.
In order to understand slope, we rst need to understand why short-maturity options have higher
expected returns and lower risk than long-maturity options. The answer lies in the eects of
gamma and embedded leverage on the supply and demand for options. Gamma (

2
OptionPrice
StockPrice
2
) is
the second derivative of option prices with respect to stock price, and it tells us how much we need
to update the hedge ratio delta when the underlying asset moves. As gamma rises, it becomes
more costly to hedge options. In fact, option market makers are known to be averse to holding
gamma risk in their portfolios, because they can lose arbitrarily large amounts of money by having
negative gamma exposure, while the premium is limited. An anecdotal example is presented in the
April 16, 2010 edition of the Wall Street Journal. The article, Option Market Makers Grapple
with Gamma Risk in Goldman, describes the real life case in which option market makers on
Goldman Sachs shares had a painful time when hedging their risk in short maturity options.
Goldman Sachs shares decrease from $184 to almost $155 when the U.S. Securities and Exchange
Commission charged the bank with fraud. Market makers had to buy and sell a massive amount
of Goldman shares in a very short amount of time. The hedging process is especially more dicult
for short maturity options, because delta the hedge ratio moves much faster for short maturity
options.
To show the importance of gamma, I prepare a simulation-based example. I consider a market
makers hedging cost of for selling $1 worth of straddles consisting of 0.5 call and -0.5 put
option across 8 maturities (1, 3, 5 days and 1, 3, 6 months and 1, 2 years). I simulate 100,000 a
day of stock price under Black-Scholes dynamics with = 0.4, = 0.15, rf = 0.04. I assume that
the market maker delta-hedges his position 16 times a day and each day consists of 16 periods in
the simulations. I dene the hedging cost as 0.2% times total dollar volume of hedging demand.
Figure 9 presents the results. Panel A reports hedging cost per day for 1$ worth option. There
34
is an enormous variation in the hedging cost across maturities. If a market maker sells 1$ worth
straddle with 1 day to maturity, he needs to spend on average 0.25 cents in transaction costs per
day. This magnitude is more than 200 times the cost of 1$ worth straddle with 1 year to maturity.
Panel B plots gamma of the same straddle positions (per dollar) across maturities. Specically, I
calculate a gamma of a straddle as the sum of call and put option gamma divided by sum of call
and put option price. Variation in gamma is very similar to the variation in hedging-cost across
maturities. Gamma of one day to maturity straddle is more than 200 times the gamma of one year
to maturity straddle. The results are not sensitive to the choice of and rf. Hedging cost per
dollar rises with . Reducing the frequency of hedging reduces the cost, but then market maker
can face a large stock price movement with a large delta.
Figure 9: Why Gamma Matters?
Panel A reports the average hedging cost per day as a percentage of option price across maturities from
10,000 simulated samples. I simulate a day of stock price under Black-Scholes dynamics with = 0.4,
= 0.15, rf = 0.04. I assume that there are 16 time periods a day. I consider the hedging cost of a market
maker for selling $1 worth of straddles consisting of 0.5 call and -0.5 put option across 8 maturities (1,
3, 5 days and 1, 3, 6 months and 1, 2 years). I assume that market maker delta-hedges his position 16 times
a day. I dene the hedging cost as 0.2% times total dollar volume of hedging demand. Red bars denote
the average hedging cost and blue lines indicate two standard deviation condence intervals. Panel B plots
gamma of same straddle positions (per dollar) across maturities. Specically, I calculate the gamma of a
straddle as the sum of call and put option gamma divided by the sum of call and put option price.
1d 3d 5d 1m 3m 6m 1y 2y
0
5
10
15
20
25
30
35
40
45
Hedging Cost
Option Price
Per Day
Panel (A)
H
e
d
g
i
n
g
C
o
s
t
Maturity
Hedging Cost
Option Price
Per Day
Panel (A)
1d 3d 5d 1m 3m 6m 1y 2y
0
5
10
15
20
25
Panel (B) 100 Gamma
1
0
0

G
a
m
m
a
Maturity
I consider the same straddle positions under six hypothetical scenarios in which the stock price
jumps, implied volatility jumps, and both stock price and implied volatility jump 5% and 10%. I
compare the instantaneous loss to market makers from selling straddles across maturities. Figure
10 Panel A and F report results with regular straddle loss and leverage-adjusted straddle loss for 5%
35
and 10% stock price jump. In both cases, we observe that the loss on straddles sharply decreases
by maturity. Panel D and E plots present the results for the third and fourth scenarios, where
implied volatility jumps 5% and 10%. Leverage-unadjusted only mildly decreases, while leverage-
unadjusted loss sharply increases. As a result, we see that price jumps impact short maturity
options and volatility jumps impact long maturity options for leverage-adjusted positions. In the
fth and sixth scenarios, I consider both price and volatility jumps. From Panel E and F, we
observe that the leverage unadjusted loss decreases only for very short maturity options (1, 3, 5
days) and rises after one month.
Table 7: The Level, Slope, Value during Price-Volatility Jumps, Recessions,
Severe Bear Markets, Market Distress and Funding Liquidity Conditions
This table reports summary statistics of the level, slope and value factors under a series of market conditions.
For each factor mean, standard deviation, t-statistics and annualized Sharpe ratios are displayed. Price jump
indicates months with at least one day with a jump in S&P 500 index, which is dened as daily change in
index of less than -4%. Non price jump denotes rest of the months. Volatility jump indicates months with
at least one day with a jump in VIX index, which is dened as daily change in VIX greater than 4%. Non
volatility jump free denotes rest of the months. Recession implies NBER recessions. Expansion denotes all
the other months. Severe bear market represents months with past 12 month S&P 500 index returns of
less than -25%. Rising market stands for rest of the months. Market return <-5% and <%-10 represents
months with contemporaneous monthly S&P 500 returns of less than -5% and -10%. High VIX (Low VIX)
corresponds to the months at the top (bottom) 25% the distribution of VIX in the sample. Thresholds
are approximately 16% and 25%. Rest of the months are denoted with Medium VIX. High (Low) funding
liquidity corresponds to the months at the bottom (top) 25% of the distribution of Ted spread in the full
sample. Thresholds are approximately 23 and 55 basis points. Rest of the months are denoted with medium
funding liquidity. High (Low) market liquidity corresponds to the months at the top (bottom) 25% of the
distribution of Pastor and Stambaugh (2003) aggregate liquidity measure. Rest of the months are denoted
by medium market liquidity. The sample covers 204 months from January 1996 to January 2013.
Level (bps) Slope (bps) Value (bps)
Nobs Mean Std T-stat SR Mean Std T-stat SR Mean Std T-stat SR
Full Sample 204 46 184 3.56 0.9 86 92 13.28 3.2 91 121 10.78 2.6
Price Jump Period 14 -200 416 -1.80 -1.7 163 164 3.73 3.5 156 151 3.86 3.6
Non Price Jump Period 190 64 141 6.27 1.6 80 82 13.37 3.4 87 118 10.15 2.6
Volatility Jump Period 39 -82 304 -1.68 -0.9 130 133 6.12 3.4 108 158 4.25 2.4
Non Volatility Jump Period 165 76 126 7.77 2.1 75 77 12.61 3.4 88 111 10.15 2.7
Recession 32 45 324 0.78 0.5 116 137 4.81 2.9 119 169 4.00 2.5
Expansion 172 46 146 4.14 1.1 80 81 13.02 3.4 86 110 10.29 2.7
Severe Bear Market 13 126 370 1.23 1.2 76 173 1.57 1.5 135 201 2.41 2.3
Rising Market 191 41 165 3.39 0.9 86 85 14.10 3.5 88 114 10.73 2.7
Market Return <-5% 25 -197 279 -3.54 -2.5 190 124 7.67 5.3 101 138 3.65 2.5
Market Return <-10% 7 -485 270 -4.75 -6.2 295 156 5.01 6.6 123 175 1.86 2.4
Low VIX 51 31 115 1.89 0.9 80 79 7.25 3.5 61 67 6.46 3.1
Medium VIX 101 37 157 2.40 0.8 85 81 10.58 3.6 77 112 6.90 2.4
High VIX 52 78 269 2.08 1.0 93 122 5.48 2.6 149 157 6.88 3.3
Low Funding Liquidity 51 12 265 0.33 0.2 104 118 6.31 3.1 139 141 7.05 3.4
Medium Funding Liquidity 102 50 147 3.46 1.2 81 79 10.41 3.6 91 108 8.43 2.9
High Funding Liquidity 51 71 151 3.38 1.6 76 87 6.23 3.0 45 107 3.03 1.5
Low Market Liquidity 51 20 261 0.55 0.3 109 113 6.86 3.3 135 155 6.22 3.0
Medium Market Liquidity 102 41 154 2.72 0.9 86 90 9.61 3.3 84 107 7.94 2.7
High Market Liquidity 51 81 142 4.08 2.0 62 64 6.91 3.4 63 99 4.56 2.2
36
From this simple exercise, we can see why option market makers are averse to having high
gamma in their positions. They cannot replicate options using stocks and bonds for short maturity
options. Even when they do, they will face large jumps. On the other hand, in my empirical
analysis, I show that short maturity options (with high gamma) do not suer from crashes as
much as long maturity options. There are two possible explanations. One, most of the price
jumps which market makers fear can be idiosyncratic and they dont impact the results from my
well-diversied portfolios. Second, market-wide price jumps which would aect my short maturity
option portfolio returns tend to occur with volatility jumps. In the simulations, I show that for
options greater than one month to maturity, the impact of volatility jumps tends to dominate for
leverage-adjusted positions.
The second important dierence between long and short maturity options is embedded lever-
age (elasticity of option price with respect to stock price). Frazzini and Pedersen (2012) argue
that securities with high embedded leverage alleviate investors leverage constraints. Therefore,
investors are willing to pay more for assets that enable them to increase their leverage. Options
with one month to maturity have about six to seven times more embedded leverage than options
with more than twelve months to maturity.
The demand-based option pricing model of Garleanu, Pedersen, and Poteshman (2009) is
related to both gamma and embedded leverage. Garleanu, Pedersen, and Poteshman (2009) argue
that risk-averse nancial intermediaries require a higher premium on options with higher demand
pressure. I dont have data on demand-pressure, but the data on trading volume shows that
more than 55% of the trading volume in notional is in the options with less than one month
to maturity during 199601-201301 sample. If most of these transactions are demand-driven, then
demand-pressure can potentially explain the maturity puzzle. Garleanu, Pedersen, and Poteshman
(2009) also show that demand pressure in one option contract increases its price by an amount
proportional to the variance of the unhedgeable part of the option. I argue that because of
gamma, the unhedgeable part of an option is larger for short maturity options.
The premium on the value factor is dicult to explain as well. It has very low correlation with
the level, the slope, dVIX and Fama-French-Carhart factors. Market-wide volatility premium
can not explain the value premium, since contemporaneous correlation between the value factor
and the innovations in VIX is very low, just -0.05. Market-wide jump premium can not be an
explanation either. The value factor tends to perform better in jump periods then non-jump
periods. Average return on the value factor is 156 basis points during price jump period (14
months) as opposed to 87 basis points during period without any price jump (190 months). The
pattern is similar but less strong during volatility jump periods, 108 basis points versus 88 basis
points. The value factor also performs slightly better during NBER recessions (119 basis points)
than expansions (86 basis points). Based on this evidence, it is hard to reconcile the premium on
value and market-wide volatility and jump premium.
37
Figure 10: Instantaneous Jump Loss on Selling ATM Straddles (Example)
Figure reports instantaneous jump loss on selling $1 worth of straddles consisting of 0.5 call and -0.5
put option across 8 maturities (1, 3, 5 days and 1, 3, 6 months and 1, 2 years). I assume that annual
Black-Scholes implied volatility is equal to 0.4. I consider 6 hypothetical scenarios. Panel A and B report
the result for the rst scenario in which stock price jumps 5% and 10%. Panel C and D report the result for
the second scenario in which Black-Scholes implied volatility jumps 5% and 10%. Panel E and F report the
result for the third scenario in which both stock price and Black-Scholes implied volatility jumps 5% and
10%. Panel A, C and E report results for regular return on selling straddle. Panel B, D and F report results
for leverage-adjusted return on selling straddle.
1d 3d 5d 1m 3m 6m 1y 2y
0
50
100
150
200
250
300
350
400
450
Panel (A)
Maturity
J
u
m
p
L
o
s
s


Instantaneous Price-Jump Loss
%10 Price Jump
%5 Price Jump
1d 3d 5d 1m 3m 6m 1y 2y
0
1
2
3
4
5
6
7
8
9
10
Panel (B)
Instantaneous Price-Jump Loss
(Leverage-Adjusted)
Maturity
L
e
v
e
r
a
g
e
-
A
d
j
u
s
t
e
d
J
u
m
p
L
o
s
s


%10 Price Jump
%5 Price Jump
1d 3d 5d 1m 3m 6m 1y 2y
0
5
10
15
20
25
30
35
40
Maturity
J
u
m
p
L
o
s
s


Panel (C)
Instantaneous Vol-Jump Loss
%10 Vol Jump
%5 Vol Jump
1d 3d 5d 1m 3m 6m 1y 2y
0
2
4
6
8
10
12
14
Panel (D)
Instantaneous Vol-Jump Loss
(Leverage-Adjusted)
Maturity
L
e
v
e
r
a
g
e
-
A
d
j
u
s
t
e
d
J
u
m
p
L
o
s
s


%10 Vol Jump
%5 Vol Jump
1d 3d 5d 1m 3m 6m 1y 2y
0
50
100
150
200
250
300
350
400
Maturity
J
u
m
p
L
o
s
s


Panel (E)
Instantaneous Price-Vol-Jump Loss
%10 Price & Vol Jump
%5 Price & Vol Jump
1d 3d 5d 1m 3m 6m 1y 2y
0
5
10
15
Panel (F)
Instantaneous Price-Vol-Jump Loss
(Leverage-Adjusted)
Maturity
L
e
v
e
r
a
g
e
-
A
d
j
u
s
t
e
d
J
u
m
p
L
o
s
s


%10 Price & Vol Jump
%5 Price & Vol Jump
Previously, Goyal and Saretto (2009) propose an alternative explanation. They conjecture
that overreaction to current stock returns leads to misestimation of future volatility, which cause
38
the value premium. Their main evidence is the underlying stock of the options in the extreme
portfolios (decile 1 and 10), which show extreme returns at the portfolio formation date. I nd
that this is true for call options. Stocks on low value (expensive) call options perform worse at
the portfolio formation month. There is still a value premium for put options, but no pattern in
the underlying stock at the portfolio formation date. Stocks on low value (expensive) put options
do not perform worse at the portfolio formation month then high value (cheap) put options. This
evidence contradicts the overreaction story.
Sch urho and Ziegler (2011) propose an explanation for option portfolios sorted on variance
risk premia. They develop a model consistent with theories of nancial intermediation under
capital constraints, in which both systematic VRP and idiosyncratic VRP are priced. I calculate
average variance risk premia (VRP) for value portfolios. VRP of low value (expensive) options are
about 0.06, compared to -0.01 VRP of high value (cheap) option portfolios, is substantially higher.
The interpretation of the value premium as compensation for risk-averse nancial intermediaries
can be considered as consistent with Sch urho and Ziegler (2011) model.
I nd another interesting pattern related to the value portfolios. The monthly growth in
the option market capital (open interest times mid-price of option) is substantially higher for
low value (expensive) option portfolios than high value (cheap) option portfolios. For instance,
monthly growth is about 20% in decile 10 (low value) option portfolio as opposed to 8% in decile
1 option portfolio at the portfolio formation month. The pattern of growth in option market
capital persists for both call and put options. We can consider the unusual growth of option
market capital as a sign of higher demand pressure for low value (expensive) option portfolios. If
so then demand-based model of Garleanu, Pedersen, and Poteshman (2009) appear to be a valid
explanation for the value premium.
If market frictions are aecting the slope and value premiums, then we should expect they are
related to funding liquidity conditions. Following Frazzini and Pedersen (2010), I proxy funding
liquidity conditions by TED spread (the dierence between 3-month LIBOR rate and 3-month
US Treasury yield) and funding liquidity risk as volatility of TED spread. Based on TED spread
full sample breakpoints (bottom and top 25%), I form three sub-samples: low, medium and high
funding liquidity samples. From Table 7, we see that the premium on the slope factor and value
factor is higher when funding liquidity conditions are tight (high TED spread). Average excess
return on the value factor rises from 45 to 139 basis points from high to low funding liquidity
sample. Similarly average excess return on the slope factor rises from 76 to 104 basis points. This
evidence shows that it is harder to exploit the slope and value premiums when funding liquidity
conditions are tight. I get similar results in sub-samples based on market liquidity. I use Pastor
and Stambaugh (2003) aggregate liquidity measure as a proxy for market liquidity.
39
Figure 11: Funding Liquidity and Excess Returns
The gure displays average monthly excess returns on selling option portfolios across moneyness-maturity
groups during dierent funding liquidity conditions. I measure funding liquidity by the TED spread at the
beginning of the holding period. I consider three sub-samples (low, medium, high funding liquidity) based
on full sample breakpoints (top and bottom 25% of TED spread). High TED spread corresponds to the time
periods with low funding liquidity. The full sample covers 204 months from January 1996 to January 2013.
See Table 4 for details of moneyness-maturity groups.
DOTM OTM ATM ITM DITM
100
50
0
50
100
150
200
250
MoneynessMaturity
E
x
c
e
s
s
R
e
t
u
r
n
(
b
a
s
i
s
p
o
i
n
t
s
p
e
r
m
o
n
t
h
)


|| 0.2
0.2 <|| 0.4
0.4 <|| 0.6
0.6 <|| 0.8
0.8 <||
High
Medium
Low
1 2 3 4 5 6 7 8 9 10
50
0
50
100
150
200
Low (Expensive) High (Cheap)
Value
E
x
c
e
s
s
R
e
t
u
r
n
(
b
a
s
i
s
p
o
i
n
t
s
p
e
r
m
o
n
t
h
)
40
Figure 12: Market Liquidity and Excess Returns
The gure displays average monthly excess returns on selling option portfolios across moneyness-maturity
groups during dierent market liquidity conditions. I measure market liquidity by the lag of Pastor and
Stambaugh (2003) aggregate liquidity measure. I consider three sub-samples (low, medium, high market
liquidity) based on full sample breakpoints (top and bottom 25% of aggregate liquidity). The full sample
covers 204 months from January 1996 to January 2013. See Table 4 for details of moneyness-maturity groups.
DOTM OTM ATM ITM DITM
100
50
0
50
100
150
200
250
MoneynessMaturity
E
x
c
e
s
s
R
e
t
u
r
n
(
b
a
s
i
s
p
o
i
n
t
s
p
e
r
m
o
n
t
h
)


|| 0.2
0.2 <|| 0.4
0.4 <|| 0.6
0.6 <|| 0.8
0.8 <||
High
Medium
Low
1 2 3 4 5 6 7 8 9 10
50
0
50
100
150
200
Low (Expensive) High (Cheap)
Value
E
x
c
e
s
s
R
e
t
u
r
n
(
b
a
s
i
s
p
o
i
n
t
s
p
e
r
m
o
n
t
h
)
41
Figure 11 presents average excess returns of the thirty moneyness-maturity portfolios and
decile value portfolios under low-medium-high TED spread conditions. From the gure, we see a
clean pattern. Average excess returns decrease from low to high TED spread conditions, but long
maturity options decrease more than short maturity options. As a result, the maturity premium
rises when funding liquidity conditions are tight. I nd that the average return on low (expensive)
value portfolio rises and on high (cheap) value portfolio decrease. Thus, the value premium is
higher when TED spread is high.
In fact, almost all option portfolio average returns are lower when the TED spread is high.
This result is counter-intuitive, since selling options requires capital. Yet it is consistent with
the ndings of Frazzini and Pedersen (2010) for BAB portfolios across asset classes. Frazzini and
Pedersen (2010) argue that a high TED spread can also mean a worsening of funding conditions.
According to this interpretation, the decrease in the average option return makes sense. However,
selling $1 worth of option with a short maturity require higher capital than selling $1 worth of
long maturity option. As a result, we should expect short maturity options to be more sensitive
to a high TED spread, but this is not what we see in the data. In any case, low average returns
during high TED spread episodes appear to be robust ndings for options and BAB portfolios.
To further investigate this nding, I regress the level, slope, and value factors on the contem-
poraneous change in the TED spread, the lag TED spread, and VIX. I nd that the lag TED
spread predicts the level with a negative coecient and the slope and value factors with positive
coecients. All three coecients are economically and statistically signicant. Detailed results
on regressions are in the appendix.
VI. Other Characteristics
To further investigate the determinants of expected option returns, I build thirteen decile portfo-
lios formed on eleven characteristics. These characteristics are option carry, variance risk premia,
volatility reversals, systematic volatility, idiosyncratic volatility, stock short-term reversal, stock
size, stock illiquidity, option illiquidity, embedded leverage and the slope of volatility term struc-
ture. I show that expected option returns are related to these characteristics. I also consider
several other stock and option characteristics, such as book-to-market ratio, market beta, stock
momentum, slope of volatility surface in moneyness direction. I do not report them, since they
do not show any signicant patterns, but the results are available upon request.
Then I test seven alternative models on decile portfolios and compare the mean absolute pricing
(MAE) implied by each model. These models are the Black-Scholes (BS), CAPM, Fama-French-
Carhart four factor model (FF4), empirical pricing model with the rst two and rst ve principal
components of the thirty moneyness-maturity portfolios, the option-two-factor model (OPT2: level
and slope), the option three-factor model (OPT3: level, slope and value). Results are on Table 8.
42
I also report details of multiple time-series regression results for the option three-factor model. T-
statistics and p-values are based on bootstrap procedure. I simulate 10,000 samples from the tted
regression residuals. I calculate standard errors of coecients are sample standard deviations and
the p-values of GRS and MAE statistics are estimated using the empirical distribution of these
statistics.
Table 8: Model Comparison
This table presents average || (pricing errors) under dierent models. BS refers to Black-Scholes, FF4 refers
to the Fama-French-Carhart four-factor model. FF5 is ve factor model with an volatility factor in addition
to FF4 factors. PCA2 and PCA5 refers to pricing model with rst two and ve principal components of the
thirty moneyness-maturity portfolios. OPT2 refers to the option two-factor model (level and slope), OPT3
the option three-factor model (level, slope and value). The sample covers 204 months from January 1996 to
January 2013.
Dependent Portfolios Alternative Models MAE
BS CAPM FF4 FF5 PCA2 PCA5 OPT2 OPT3
Moneyness-Maturity 44 38 37 41 31 21 13 15
Value 38 32 31 30 34 26 21 10
Carry 66 53 47 39 43 19 13 10
Variance Risk Premia 29 19 15 12 24 13 14 9
Volatility reversals 31 21 17 16 25 10 9 6
Systematic Volatility 33 23 18 5 26 8 11 7
Idiosyncratic Volatility 34 24 19 9 25 7 10 8
Stock Risk Reversal 32 27 22 11 24 14 14 14
Size 54 44 36 25 41 22 23 17
Stock Illiquidity 50 39 33 23 41 21 20 13
Option Illiquidity 48 35 28 9 30 18 13 10
Embedded Leverage (1) 240 196 162 110 146 83 62 61
Embedded Leverage (2) 34 24 19 13 27 14 14 12
Slope of Volatility Term Structure (S) 64 57 54 39 40 11 7 8
Slope of Volatility Term Structure (L) 18 15 15 25 26 22 22 22
Open Interest Gamma 32 22 20 20 26 19 16 12
A. Carry
Expected return of an asset can be broken down into two components, the carry and the expected
price change components. A carry trade involves going long in high carry assets and short in low
carry assets. Traditionally, carry is applied only to currencies, but Koijen, Moskowitz, Pedersen,
and Vrugt (2012) generalize carry to other asset classes such as global equities, bonds, currencies,
and commodities, as well as within US Treasuries, credit, and equity index options. I complement
43
their work by applying carry to individual equity options. According to my knowledge, this is the
rst study of carry trade in individual equity option market. Particularly for equity options, carry
is dened as expected return if the underlying stock price and implied volatility term structure do
not change. Option carry has time-decay and roll-down components. I calculate the time-decay
component using Black-Scholes theta and the roll-down component using Black-Scholes vega and
implied volatility surface. See the Methodology section for the details of carry denitions.
I sort options into decile portfolios based on their carry. Table 9 Panel A reports the summary
statistics as well as the results from multiple time-series regressions. I nd that carry strategies
perform extremely well in individual equity options. Both annualized Sharpe ratios and monthly
average returns rise smoothly from decile one (9 basis point, 0.26) to decile ten (257 basis point,
2.18). The spread between the excess return on decile ten and one portfolio has an enormous
Sharpe ratio of 2.5, which is larger than the Sharpe ratio of carry strategies considered in Koijen,
Moskowitz, Pedersen, and Vrugt (2012) in any asset class.
Table 8 compares the MAEs from seven dierent models. Mean absolute average return or
MAE of BS is 66 basis points. CAPM and FF4 can reduce the pricing errors to around 50 basis
points. I nd that the option three-factor model performs really well in explaining the returns
of these portfolios. MAE is less than 10 basis points. Except for the decile 8 portfolio, all the
t-statistics of alphas are insignicant. P-value of MAE and GRS statistics are 0.38 and 0.04.
Cross-sectional variation of expected returns on carry portfolios are captured by both the level
and the slope coecients. The level coecients are low for low carry portfolios just like long
maturity in-the-money options. Coecients of slope factor are negative for low carry options and
positive for high carry option portfolios. This is not surprising since carry varies systematically by
moneyness and maturity characteristics. The option three-factor model also explains the realized
return variation, average R
2
is close to 90%. Therefore we can interpret the results on carry
portfolios as an application of Arbitrage Pricing Theory of Ross (1976).
B. Variance Risk Premia (VRP)
VRP is dened as the dierence between the expected future stock return variation in the risk-
neutral measure and physical measure. For expected return variation in risk-neutral measure, I
estimate model-free implied volatility as in Han and Zhou (2012) using a cross-section of option
prices. For the expected stock return variation in the physical measure, I estimate ex-post return
variation in the past month using high frequency data.
There is a large literature on VRP. Previously Bollerslev, Tauchen, and Zhou (2009) show
that VRP on the S&P 500 index forecast future index returns. Han and Zhou (2012) show
that a stocks expected return increases with its VRP. Sch urho and Ziegler (2011) constructed
synthetic individual equity variance swaps using a cross-section of individual equity option prices.
44
Then, they show that both systematic and idiosyncratic VRP are related to the average returns
on variance swaps. In this section, I examine the relation between VRP and individual option
returns, instead of synthetic variance swaps.
In order to build VRP portfolios, I initially sort options into decile portfolios by size (shares
outstanding time stock price), then within each size group I form decile portfolios formed on
VRP. As a result, I have 100 portfolios formed by sequentially sorting options rst by size then
by VRP. This way, I have ten separate decile one VRP portfolio across ten dierent size groups.
Then I aggregate decile one VRP portfolios into one portfolio by estimating option market capital
weighted average. I do same thing from decile two to ten.
Let R
e
i,j,t
be excess return of portfolio that belongs to size group i and VRP group j at time t.
Note that there is one VRP group j within each size group. Let v
i,j,t
be option market capital of
portfolio that belongs to size group i and VRP group j at time t. I dene option market capital of
a portfolio as the sum of open interest times mid-price of all options that make up the portfolio.
R
e
j,t
=

10
i=1
v
i,j,t
R
e
i,j,t

10
i=1
v
i,j,t
I call R
e
j,t
as the excess return on decile j VRP portfolio at time t. Table 8 Panel B reports
average returns across decile portfolios. Average return on decile 10-1 is 49 basis points (5.3 t-
statistics and 1.29 Sharpe ratio). The option three-factor explains the excess returns on these
portfolios. GRS statistics do not reject the model (p-value 0.18). Generally, the coecient of
value factor captures the average return dierential between low VRP and high VRP portfolios.
A fair question is why do I bother with controlling for size, when I form VRP portfolios? The
VRP characteristic tends to be extreme in small companies, which have high expected option
returns. If I dont control for size, decile 1 and 10 portfolios will consists of options on small
companies. As a result, we observe a U-shaped expected return. I dont report results for those
portfolios, but they are available upon request.
C. Volatility Reversals
Reversal eect is the relation between the expected return of a security and its recent performance.
Options do not have a long maturity and they change character very quickly; therefore, it is not
good idea to dene reversal in terms of an options past return. The primary determinant of a
expected option return is moneyness and maturity; hence I decided to estimate reversal of an
option using Black-Scholes implied volatility for a given moneyness (||) and maturity. Suppose
we have an option on stock i with delta , time-to-maturity T and Black-Scholes implied volatility

i,t
(, T) at time t. I dene reversal for this option as
i,t
(, T)
i,t1
(, T) the monthly change
in the implied volatility for a given moneyness and maturity. The implicit assumption here is that
45
the name of asset does not matter, characteristics matter. We can describe an option by its
moneyness, maturity and underlying stock rather than optionid. Note that I interpret Black-
Scholes implied volatility as a measure of price, and therefore volatility reversals is basically price
appreciation.
In order to build volatility reversals portfolios, I initially sort options into thirty portfolios by
ve moneyness and six maturity groups, then within each moneyness-maturity group, I build decile
portfolios formed on volatility reversals. As a result, I have 300 portfolios formed by sequentially
sorting options rst by moneyness-maturity then by volatility reversals. This way, I have thirty
separate decile one volatility reversals portfolio across thirty dierent moneyness-maturity groups.
Then I aggregate decile one volatility reversals portfolios into one portfolio by estimating option
market capital weighted average. I do same thing from decile two to ten.
Let R
e
i,j,k,t
be excess return of portfolio that belongs to moneyness group i, maturity group j
and volatility reversals group k at time t. Note that there is one volatility reversals group k within
each moneyness-maturity group. Let v
i,j,k,t
be option market capital of portfolio that belongs to
the same moneyness, maturity and volatility reversals group. I dene option market capital of a
portfolio as the sum of open interest times mid-price of all options that make up the portfolio.
R
e
k,t
=

5
i=1

6
j=1
v
i,j,k,t
R
e
i,j,k,t

5
i=1

6
j=1
v
i,j,k,t
I call R
e
k,t
as the excess return on decile k volatility reversals portfolio at time t. According to
Table 9 Panel C, both average returns and Sharpe ratios rise from low to high volatility reversals
portfolios. The dierence between high and low volatility portfolios have a considerable Sharpe
ratio of 1.4. GRS statistics (joint test of all pricing errors equal to zero) fail to reject the option
three-factor model. MAE of the model is about six basis points, which is considerable progress
compared to mean absolute average return of 31 basis points. Generally, coecients of the slope
factor and the value factor capture the expected return variation between high-low portfolios.
D. Systematic and Idiosyncratic Volatility
Cao and Han (2012) dene idiosyncratic volatility IV OL
i,t
as the volatility of residuals from the
Fama-French three-factor model, which is estimated using daily data over the previous month.
They dene systematic volatility as the
_
V OL
2
i,t
IV OL
2
i,t
, where V OL
i,t
is the volatility of
daily returns of stock i in month t. Cao and Han (2012) nd that option returns are related
to idiosyncratic volatility of the underlying asset. In their analysis, they use at-the-money short
maturity (shortest maturity greater than one month) options. I extend their analysis to the
all moneyness and maturity groups. Their nal sample has about 400,000 observations, while I
conduct this study with more than 11 million observations.
46
My results are consistent with Cao and Han (2012). Expected option returns on high idiosyn-
cratic volatility portfolios are higher than low ones. This pattern can not be explained by usual risk
adjustment models. I nd that the option three-factor model successfully explains this pattern.
GRS statistics do not reject the model with a p-value of 0.16. None of the t-statistics of alphas
are signicant. Alpha of high minus low volatility portfolio is just 3 basis point, while the average
return of high minus low portfolio is 58 basis points. Generally, variation on the coecient of the
level factor captures the expected return variation. I did not nd any robust pattern related to
systematic volatility.
E. Stock Short-Term Reversal
Ang, Bali, and Cakici (2010) dene short-term reversal as the stock return over the previous
month. They nd that the past stock return predicts future call implied volatilities on the same
stock, but they did not nd any pattern for put option implied volatilities. Their ndings are
based on standardized at-the-money options with thirty days to maturity.
In order to investigate the economic signicance of this nding, I build portfolios formed on
past stock return using the actual option prices for all moneyness and maturity groups. I form
separate portfolios for call and put options. My results are consistent with ndings of the Ang,
Bali, and Cakici (2010). I nd an economically signicant pattern for call options and no pattern
for put options. In Table 9 Panel F, I report results for only call option portfolios. Average returns
rise smoothly from 11 basis points to 88 basis points. Sharpe ratio of decile 10-1 portfolios is more
than one. The option three-factor model does a decent job at pricing these portfolios. MAE is
only 14 basis points and p-value of GRS statistics is 0.03. Except for decile 9 portfolios, t-statistics
of all alphas are insignicant.
F. Stock Size
The rm size is a natural logarithm of the market value of an equity, which is estimated as the
stock price times the number of shares outstanding. Although size premium attracts enormous
amount of attention in the stock market, not much attention is paid to it in the empirical option
pricing literature. Previously, Di Pietro and Vainberg (2006) document that size of the underlying
stock is related to the returns of synthetic variance swaps. I nd a considerable amount of size
premium in the option market. Expected returns on options on small rms are substantially larger
than large ones. Average returns rise from 24 basis points to 138 basis points. Small minus big
portfolio has a Sharpe ratio of almost 2.3. GRS statistics decisively reject the option three-factor
model, but the model still shows some success. Mean absolute average return is 54 basis points
on size portfolios. The option three-factor model leaves MAE of only 17 basis points. Compared
47
to MAE of CAPM 44 and FF4 of 36 basis points, 17 basis points is considerable progress. The
model fails to price the smallest two portfolios.
G. Stock Illiquidity and Option Illiquidity
I follow Amihud (2002) for the denition of stock illiquidity and Christoersen, Goyenko, Jacobs,
and Karoui (2011) for the denition of option illiquidity. Stock illiquidity is dened as the ratio of
the absolute value of stock return in the past month to the total dollar volume on that stock
|R
i,t
|
V
i,t
,
where R
i,t
is the month t return of stock i, and V
i,t
the total dollar volume of stock i in month t.
Option illiquidity is dened as the ratio of the bid-ask spread to mid price
bidask
(bid+ask)/2
.
My results on stock illiquidity are consistent with the ndings of Christoersen, Goyenko,
Jacobs, and Karoui (2011). Options on illiquid stocks are more expensive, since the cost of
replicating options on illiquid stocks are higher for market makers. Consequently, the expected
return on selling options is considerably higher for options on illiquid stocks than liquid stocks.
Results of Christoersen, Goyenko, Jacobs, and Karoui (2011) is based on the options on stocks
that are exclusively S&P 500 index constituents. They also limit their sample to rms that have
option trading throughout the entire sample period, which reduces their sample to 341 rms. They
consider options with delta range 0.125 || 0.875 and time-to-maturity range 20 to 180 days.
I conrm their results with more than 7,500 stocks and all moneyness-maturity categories.
Table 9 Panel H reports the results on decile portfolios formed on stock illiquidity. There is a
rising pattern of average returns and Sharpe ratios between option portfolios on liquid stocks and
illiquid stocks. Decile 10-1 (illiquid-liquid) has an average return of 103 basis points and Sharpe
ratio of 1.64. Table 8 report the MAEs across alternative models. The option three-factor model
successfully explains the returns on these portfolios, while the usual risk-adjustment models all
fail. GRS statistics fail to reject the option three-factor model with p-value of 0.20. Moreover,
MAE of the model is just 13 basis points, while mean(

E
_
R
e
i,t
_

)=50.
My results on option illiquidity contradicts the results of Christoersen, Goyenko, Jacobs, and
Karoui (2011), which imply that buyers of options earn an illiquidity premium. My results imply
an illiquidity premium for the sellers. In other words, Christoersen, Goyenko, Jacobs, and Karoui
(2011) nd that illiquid options are cheaper and I nd that illiquid options are more expensive.
Theoretical models on zero net supply derivatives such as Bongaerts, De Jong, and Driessen (2011),
tells that the sign of the illiquidity premium depends on the risk aversion of the buyers and sellers.
My results are consistent with more risk averse buyers and Christoersen, Goyenko, Jacobs, and
Karoui (2011)s results are consistent with more risk averse sellers. Given that options are a type
of insurance, I argue that buyers should be more risk averse.
Average returns rise on selling options rise from 26 basis points to 80 basis points, as we go
from liquid to illiquid option portfolios. Although GRS statistics rejects the option three-factor
48
model, the model does a decent job at explaining the expected returns MAE of the model is just
10 basis points, while mean(

E
_
R
e
i,t
_

) = 48.
H. Embedded Leverage
Frazzini and Pedersen (2012) show that investors require lower returns on assets with higher
embedded leverage. The denition of embedded leverage is the elasticity of the option price with
respect to the stock price. In practice I use the delta from the Black-Scholes model. I denote
embedded leverage with .
=

F
F
S
S

S
F
F
S

=
S
F
||
I build two sets of decile portfolios formed on embedded leverage. In the rst set, I directly
sort options into portfolios by their embedded leverage, but I use leverage-unadjusted returns of
options. When I use leverage-adjusted returns, I can not nd a clear pattern. In the second set
of decile portfolios, I use standard leverage-adjusted returns but control for moneyness-maturity
when building portfolios. My portfolio construction methodology is exactly same as the way I
construct volatility reversals portfolios, so see the volatility reversals part for details.
Table 9 Panel J reports the results for the rst set of embedded leverage portfolios with leverage-
unadjusted returns. The results are consistent with the ndings of Frazzini and Pedersen (2012).
Both average returns and Sharpe ratios rise from low to high embedded leverage portfolios from
0.7% to 9.4% monthly average returns and 0.64 to 1.82 annualized Sharpe ratio. Mean(

E
_
R
e
i,t
_

)
or MAE according to Black-Scholes model is 240 basis points. CAPM and FF4 reduce MAE
to only 196 and 192 basis points, while the option three-factor reduce it to 61 basis points. The
explanatory power of the option three-factor model comes from the variation in the level and slope
betas. The beta of the level rises smoothly from 1.5 to 8.5 from low to high embedded leverage
portfolios. Similarly, the beta of the slope rises from -0.7 to 2.6.
Table 9 Panel K reports the results for the second set of embedded leverage portfolios in
which I control for moneyness-maturity when forming portfolios. This time, the expected return
embedded leverage pattern is completely reversed. This result seems counter intuitive at rst, but
it has a reasonable explanation. When I control for moneyness and maturity, the only variation in
embedded leverage ( =
S
F
||) will come from the variation of the ratio of stock price to option
price S/F. High becomes high S/F, which means option price is low relative to stock price.
As a result, bet on embedded leverage turning into a value style investment. High embedded
leverage corresponds to cheap options. As expected, expected return on selling cheap options
(high embedded leverage) is lower than selling expensive options (low embedded leverage). Note
that here cheap means the option price is cheap relative to stock price.
In the second set of portfolios, average returns decrease slowly from 113 basis points to 10
49
basis points. Although the option three-factor model explains about two thirds of the expected
returns (mean(

E
_
R
e
i,t
_

) = 32, MAE = 12), GRS test rejects the model. Specically, the option
three-factor model has diculty at pricing low embedded leverage (expensive) option portfolios.
I. Slope of Volatility Term Structure
I dene slope of volatility structure as the dierence between implied volatility of at-the-money
(|| = 0.5) options with 365 days to maturity and 30 days to maturity. This characteristic is
dened separately for both call and put options. Vasquez (2012) show that there is a negative
relation between the slope of volatility term structure and expected return on selling options.
Their analysis is based on at-the-money options with one month to maturity.
I interpret the ndings of Vasquez (2012) as another application of value-style investment.
Most of the variation in slope of volatility term structure comes from the variation in the implied
volatility of short term options, since the implied volatility of long term options is more stable.
Low slope of volatility term structure means high implied volatility for short-term options. In
other words price of short-term options is high relative to the price of long-term options.
I build two sets of decile portfolios formed on the slope of volatility term structure. The
rst decile portfolios consists of short-term options with less than or equal to three months to
maturity. The second decile consists of long-term options with greater than 3 months to maturity.
I do this separation, because I observe completely opposite patterns related to expected returns
between short-term and long-term decile portfolios. Actually opposite pattern is consistent with
my interpretation of value style investment for these portfolios. In both set of decile portfolios,
expected returns are higher for expensive options.
My results on short-term option decile portfolios are consistent with the ndings of Vasquez
(2012). Average returns rise from 57 basis points to 187 basis points from low to high portfolios.
High minus low portfolio has an Sharpe ratio of 1.84. Usual risk-adjustment models dont explain
these patterns, but the option three-factor model does. GRS statistics fail to reject the option
three-factor model with p-value of 0.86. MAE of the model is only 8 basis points. while the
mean(

E
_
R
e
i,t
_

) is 64 basis points.
The average return pattern is less strong and reversed in the second set of decile portfolios
formed on slope of volatility term structure. Average returns decrease from 57 basis points to 20
basis points, but the pattern is not smooth. Yet, the high minus low portfolios have signicant
average return with t-statistics -2.78. The option three-factor model fail at pricing return on these
option portfolios in every aspect. GRS test rejects the model. Moreover, MAE of the model is 22
basis points, which is even greater than mean(

E
_
R
e
i,t
_

) of 18 basis points.
50
J. Open Interest Gamma
I hypothesize that market makers are averse to having too much total gamma on options on a
given stock. Based on this motivation, I construct a new characteristic, open interest gamma,
which is dened as the sum of open interest times gamma of all options for a given underlying
stock divided by the market capital of that underlying stock. Note that options on the same
underlying stock share the exact same open interest gamma.
If my hypothesis is correct, options with high open interest gamma should be expensive, hence
selling them should generate a higher expected return. In order to test this hypothesis, I sort
options into decile portfolios by their open interest gamma. Table 9 Panel N reports the results,
which conrm my hypothesis. Expected returns rise from 9 basis points to 95 basis points, Sharpe
ratios rises from 0.18 to 1.35 from low the high open interest gamma portfolios. 10-1 decile portfolio
excess return has a Sharpe ratio of 1.72 and t-statistic of 7.11.
I test OPT3 on decile portfolios formed on open interest gamma. GRS test rejects OPT3 at
0.05 signicance level, but not at 0.01 signicance level. Overall, OPT3 does a decent job at
pricing these portfolio returns. Only of decile 8 portfolio has a signicant t-statistics. MAE of
the model is only 12 basis points. while the mean(

E
_
R
e
i,t
_

) is 32 basis points.
Table 9: Characteristic Based Option Portfolio Summary Statistics and Asset
Pricing Tests
This table reports summary statistics, results of multiple time-series regressions and asset pricing tests. Sum-
mary statistics are on excess returns (delta-hedged, leverage-adjusted) of decile portfolios based on several
characteristics. Mean, standard deviation, t-statistics and annualized Sharpe ratio of monthly (holding pe-
riod) percentage excess returns are reported. Then I test the option three-factor model on decile portfolios. I
report s, slope coecients, t-statistics and R-squares. GRS is the joint test of all pricing errors. I run OLS
with 10,000 bootstrap simulations under the null hypothesis of zero pricing errors to estimate t-statistics
and p-values.
L
,
S
,
V
are slope coecients of the level, slope, value factors respectively. R
e
i,t
is excess
return on portfolio i at time t. The sample covers 204 months from January 1996 to January 2013. Panel
A reports the results for decile portfolios formed on carry. Panel B reports the results for decile portfolios
formed on variance risk premia. I control for the size of underlying stock, when forming variance risk premia
portfolios. Panel C reports the results for decile portfolios formed on volatility reversals. Note that I control
for moneyness and maturity when forming volatility reversals portfolios. Panel D and E reports results for
systematic and idiosyncratic volatility. Panel F report the results for decile portfolios formed on stock risk
reversal. Note that I only keep call options when forming stock short-term reversal portfolios. Panel G,
H and I report the results for decile portfolios formed on stock size, stock illiquidity and option illiquidity.
Panel J and K report the results for decile portfolios formed on embedded leverage. In Panel J, excess
returns are leverage-unadjusted returns. In Panel K, excess returns are standard leverage-adjusted returns,
but I control for moneyness and maturity when forming portfolios. Panel L and M report the results for
decile portfolios formed on slope of volatility term structure. In Panel L, I use options with less than or
equal to three months when forming portfolios. In Panel K, I use long maturity options (greater than three
months to maturity) when forming portfolios. Panel N report results for open interest gamma. See Section
II for the characteristic denitions.
R
e
i,t
=
i
+
L
i
Level
t
+
s
i
Slope
t
+
v
i
V alue
t
+
i,t
i {1, 2, ..., 10, 10 1}
51
Panel A: Option Carry Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
Carry Low High
Mean 0.09 0.13 0.15 0.19 0.24 0.40 0.58 0.92 1.32 2.57 2.48
Std. Dev. 1.21 1.51 1.70 1.90 2.06 2.25 2.56 2.69 3.06 4.08 3.44
t(Mean) 1.07 1.25 1.25 1.41 1.67 2.55 3.23 4.88 6.18 9.00 10.30
Sharpe R 0.26 0.30 0.30 0.34 0.41 0.62 0.78 1.18 1.50 2.18 2.50
0.09 0.03 -0.02 -0.04 -0.04 -0.06 -0.06 0.24 0.18 0.21 0.11
t() 1.38 0.47 -0.36 -0.61 -0.52 -0.84 -0.67 2.36 1.59 0.81 0.40 1.94 0.04

L
0.50 0.68 0.80 0.90 0.98 1.12 1.29 1.36 1.66 2.20 1.70

S
-0.28 -0.29 -0.27 -0.27 -0.28 -0.18 -0.16 -0.10 0.28 1.17 1.45

V
0.01 0.04 0.04 0.05 0.08 0.11 0.19 0.16 0.15 0.38 0.37
R
2
0.81 0.91 0.93 0.91 0.92 0.93 0.93 0.91 0.91 0.75 0.58
Panel B: Variance Risk Premia Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GdRS)
VRP Low High
Mean 0.16 0.13 0.17 0.23 0.23 0.25 0.35 0.33 0.37 0.65 0.49
Std. Dev. 2.31 1.91 1.64 1.75 1.59 1.69 1.80 1.79 1.98 2.27 1.32
t(Mean) 1.00 0.94 1.49 1.90 2.02 2.13 2.79 2.67 2.65 4.09 5.30
Sharpe R 0.24 0.23 0.36 0.46 0.49 0.52 0.68 0.65 0.64 0.99 1.29
-0.04 -0.16 -0.11 -0.03 -0.01 -0.02 -0.01 0.15 0.24 0.17 0.21
t() -0.32 -2.01 -1.50 -0.36 -0.12 -0.19 -0.13 1.51 1.88 1.43 1.28 1.40 0.18

L
1.06 0.92 0.79 0.79 0.71 0.75 0.81 0.77 0.79 1.07 0.01

S
-0.24 -0.16 -0.13 -0.22 -0.24 -0.24 -0.18 -0.30 -0.36 -0.17 0.07

V
-0.09 0.00 0.03 0.09 0.12 0.14 0.16 0.10 0.08 0.15 0.24
R
2
0.82 0.88 0.87 0.83 0.84 0.82 0.80 0.80 0.73 0.84 0.05
Panel C: Volatility reversals Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
Vol. Mom. Low High
Mean 0.23 0.14 0.18 0.21 0.21 0.22 0.22 0.30 0.40 1.02 0.79
Std. Dev. 2.70 2.12 1.98 1.86 1.77 1.63 1.55 1.49 1.78 2.27 1.90
t(Mean) 1.24 0.93 1.28 1.59 1.69 1.89 2.01 2.83 3.19 6.42 5.91
Sharpe R 0.30 0.23 0.31 0.39 0.41 0.46 0.49 0.69 0.77 1.56 1.43
0.16 0.01 0.06 0.06 -0.01 -0.05 -0.11 -0.00 -0.02 0.09 -0.07
t() 1.03 0.12 0.63 0.71 -0.16 -0.67 -1.39 -0.03 -0.17 0.72 -0.31 0.92 0.52

L
1.11 0.95 0.88 0.83 0.82 0.76 0.73 0.69 0.84 1.10 -0.01

S
-0.55 -0.28 -0.34 -0.32 -0.25 -0.19 -0.12 -0.12 -0.11 0.08 0.63

V
0.04 -0.08 0.00 0.04 0.06 0.09 0.10 0.09 0.13 0.39 0.35
R
2
0.79 0.83 0.86 0.86 0.88 0.86 0.83 0.82 0.82 0.80 0.17
52
Panel D: Systematic Volatility Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
Sys.Vol. Low High
Mean 0.30 0.32 0.33 0.26 0.23 0.17 0.27 0.30 0.23 0.55 0.24
Std. Dev. 1.14 1.23 1.31 1.36 1.53 1.49 1.65 1.76 2.16 2.45 2.13
t(Mean) 3.80 3.68 3.58 2.76 2.19 1.59 2.38 2.44 1.53 3.19 1.64
Sharpe R 0.92 0.89 0.87 0.67 0.53 0.39 0.58 0.59 0.37 0.77 0.40
0.17 0.02 0.05 0.02 0.03 -0.26 -0.01 -0.03 -0.29 0.04 -0.13
t() 1.83 0.24 0.47 0.22 0.26 -2.31 -0.09 -0.20 -1.79 0.21 -0.54 1.64 0.11

L
0.42 0.48 0.54 0.52 0.62 0.65 0.69 0.71 0.99 1.04 0.62

S
-0.16 -0.10 -0.06 -0.08 -0.09 0.05 -0.07 -0.01 0.19 0.11 0.28

V
0.09 0.18 0.09 0.08 -0.01 0.10 0.03 0.01 -0.11 -0.08 -0.17
R
2
0.58 0.60 0.63 0.56 0.62 0.63 0.63 0.56 0.64 0.57 0.24
Panel E: Idiosyncratic Volatility Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
Idio. Vol. Low High
Mean 0.19 0.14 0.13 0.23 0.29 0.27 0.32 0.40 0.44 0.77 0.58
Std. Dev. 1.09 1.43 1.34 1.47 1.65 1.78 1.69 1.87 1.84 2.42 1.95
t(Mean) 2.49 1.40 1.40 2.25 2.52 2.18 2.73 3.07 3.38 4.52 4.21
Sharpe R 0.60 0.34 0.34 0.54 0.61 0.53 0.66 0.75 0.82 1.10 1.02
-0.08 0.24 -0.06 0.04 -0.09 -0.12 -0.14 -0.08 0.17 -0.07 0.01
t() -0.84 1.92 -0.56 0.33 -0.74 -0.85 -1.12 -0.59 1.24 -0.35 0.03 1.44 0.16

L
0.44 0.45 0.51 0.56 0.74 0.75 0.80 0.84 0.79 1.08 0.64

S
-0.04 -0.34 -0.15 -0.15 0.05 -0.03 0.16 0.10 -0.04 0.36 0.40

V
0.11 -0.01 0.09 0.07 -0.01 0.07 -0.05 0.01 -0.07 0.03 -0.08
R
2
0.59 0.53 0.59 0.59 0.67 0.62 0.67 0.64 0.64 0.56 0.27
Panel F: Stock Short-Term Reversal Portfolios (Only Call)
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
S. Rev. High Low
Mean 0.11 0.16 0.16 0.21 0.26 0.31 0.28 0.38 0.47 0.88 0.78
Std. Dev. 1.76 1.51 1.28 1.50 1.39 1.52 1.55 1.74 1.93 2.69 2.38
t(Mean) 0.87 1.50 1.84 1.97 2.63 2.89 2.59 3.12 3.45 4.69 4.65
Sharpe R 0.21 0.36 0.45 0.48 0.64 0.70 0.63 0.76 0.84 1.14 1.13
-0.24 -0.18 -0.09 0.14 -0.05 -0.11 -0.12 0.09 0.31 0.08 0.33
t() -1.52 -1.46 -0.88 1.13 -0.43 -0.95 -1.07 0.73 2.06 0.38 1.18 2.03 0.03

L
0.67 0.63 0.54 0.54 0.59 0.65 0.70 0.74 0.76 1.13 0.46

S
0.09 0.01 -0.02 -0.21 -0.02 0.03 0.02 -0.14 -0.19 0.15 0.06

V
-0.03 0.04 0.03 -0.00 0.05 0.10 0.07 0.08 -0.04 0.16 0.20
R
2
0.46 0.60 0.61 0.56 0.62 0.61 0.68 0.68 0.61 0.56 0.13
53
Panel G: Stock Size Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
Size High Low
Mean 0.24 0.22 0.23 0.30 0.38 0.36 0.60 0.66 1.06 1.38 1.14
Std. Dev. 1.64 1.88 1.98 1.93 2.00 2.04 2.36 2.33 2.06 2.48 1.75
t(Mean) 2.07 1.69 1.67 2.25 2.71 2.50 3.61 4.03 7.37 7.95 9.34
Sharpe R 0.50 0.41 0.40 0.55 0.66 0.61 0.88 0.98 1.79 1.93 2.27
0.03 -0.05 -0.11 0.00 0.20 -0.02 0.12 -0.10 0.57 0.48 0.45
t() 0.50 -0.62 -1.24 0.02 2.03 -0.18 0.72 -0.63 4.32 2.58 2.15 3.49 0.00

L
0.75 0.90 0.95 0.90 0.89 0.95 0.99 1.09 0.88 1.10 0.35

S
-0.27 -0.14 -0.19 -0.22 -0.33 -0.17 -0.14 0.05 -0.21 0.12 0.39

V
0.10 -0.02 0.07 0.08 0.06 0.09 0.15 0.23 0.29 0.32 0.22
R
2
0.89 0.87 0.88 0.85 0.84 0.82 0.66 0.73 0.74 0.65 0.12
Panel H: Stock Illiquidity Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
S.Illiq. Low High
Mean 0.28 0.20 0.28 0.22 0.32 0.43 0.58 0.53 0.91 1.30 1.03
Std. Dev. 1.65 1.76 1.91 1.89 2.02 2.13 2.08 2.31 2.43 2.71 2.17
t(Mean) 2.38 1.65 2.07 1.65 2.29 2.88 3.98 3.25 5.32 6.85 6.76
Sharpe R 0.58 0.40 0.50 0.40 0.55 0.70 0.96 0.79 1.29 1.66 1.64
0.09 -0.04 -0.12 0.06 0.01 0.02 -0.01 0.21 -0.05 0.67 0.58
t() 1.39 -0.55 -1.44 0.65 0.08 0.17 -0.10 1.51 -0.31 2.53 2.16 1.36 0.20

L
0.78 0.84 0.91 0.83 0.92 0.98 0.94 0.97 1.11 0.89 0.11

S
-0.21 -0.20 -0.18 -0.36 -0.27 -0.20 -0.08 -0.38 0.10 -0.09 0.12

V
0.00 0.04 0.14 0.10 0.14 0.15 0.25 0.22 0.39 0.33 0.32
R
2
0.89 0.89 0.88 0.86 0.84 0.82 0.74 0.77 0.70 0.40 0.04
Panel I: Option Illiquidity Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
O.Illiq Low High
Mean 0.26 0.24 0.26 0.34 0.41 0.49 0.62 0.66 0.78 0.80 0.54
Std. Dev. 1.44 1.76 1.89 2.03 2.22 2.36 2.54 2.74 3.09 3.65 2.72
t(Mean) 2.55 1.92 1.95 2.40 2.67 2.94 3.48 3.44 3.63 3.11 2.84
Sharpe R 0.62 0.47 0.47 0.58 0.65 0.71 0.84 0.83 0.88 0.76 0.69
0.08 0.02 -0.06 -0.01 0.00 0.16 0.18 0.14 -0.02 -0.34 -0.43
t() 1.28 0.36 -1.05 -0.12 0.01 1.94 1.54 1.16 -0.14 -1.49 -1.71 3.29 0.00

L
0.67 0.83 0.91 0.99 1.08 1.12 1.18 1.30 1.48 1.69 1.02

S
-0.17 -0.28 -0.27 -0.27 -0.23 -0.33 -0.30 -0.28 -0.15 -0.04 0.13

V
0.01 0.08 0.14 0.14 0.13 0.11 0.17 0.18 0.28 0.44 0.43
R
2
0.87 0.94 0.94 0.95 0.92 0.92 0.87 0.88 0.83 0.75 0.47
54
Panel J: Embedded Leverage Portfolios (Leverage-Unadjusted Returns)
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
E.Lev.(1) Low High
Mean 0.66 0.63 0.63 0.75 0.88 1.31 1.92 2.84 5.06 9.37 8.72
Std. Dev. 3.55 4.18 5.18 6.19 7.20 8.60 9.85 11.58 13.71 17.81 15.50
t(Mean) 2.63 2.16 1.73 1.72 1.75 2.18 2.78 3.50 5.27 7.51 8.03
Sharpe R 0.64 0.52 0.42 0.42 0.42 0.53 0.67 0.85 1.28 1.82 1.95
0.45 0.44 0.27 0.41 0.18 -0.06 -0.03 -0.18 0.58 3.47 3.02
t() 2.26 1.99 1.07 1.39 0.59 -0.15 -0.06 -0.28 0.75 2.69 2.33 2.36 0.01

L
1.47 1.77 2.25 2.72 3.29 4.10 4.78 5.82 7.17 8.63 7.17

S
-0.77 -0.88 -1.02 -1.16 -1.14 -0.76 -0.48 0.53 1.81 2.60 3.36

V
0.20 0.15 0.22 0.09 0.18 0.15 0.17 -0.13 -0.40 -0.32 -0.52
R
2
0.80 0.83 0.85 0.86 0.88 0.87 0.85 0.81 0.80 0.67 0.56
Panel K: Embedded Leverage Portfolios
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
E.Lev.(2) Low High
Mean 1.13 0.48 0.38 0.30 0.26 0.20 0.19 0.19 0.16 0.10 -1.03
Std. Dev. 3.20 2.37 2.11 1.94 1.80 1.70 1.54 1.43 1.28 1.14 2.49
t(Mean) 5.05 2.89 2.59 2.23 2.09 1.70 1.77 1.86 1.80 1.21 -5.94
Sharpe R 1.22 0.70 0.63 0.54 0.51 0.41 0.43 0.45 0.44 0.29 -1.44
0.46 0.24 0.25 -0.01 -0.04 0.00 -0.08 0.02 -0.03 -0.06 -0.52
t() 2.47 2.41 3.10 -0.15 -0.50 0.02 -1.31 0.21 -0.40 -0.87 -2.47 3.30 0.00

L
1.38 1.09 0.98 0.95 0.89 0.81 0.74 0.63 0.58 0.50 -0.89

S
-0.43 -0.36 -0.31 -0.15 -0.11 -0.18 -0.15 -0.22 -0.15 -0.15 0.27

V
0.43 0.05 -0.06 0.01 -0.02 -0.02 0.07 0.07 0.05 0.06 -0.37
R
2
0.78 0.88 0.90 0.90 0.89 0.89 0.89 0.83 0.82 0.78 0.54
Panel L: Slope of Volatility Term Structure Portfolios (Short)
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
Slope(S) High Low
Mean 0.57 0.41 0.37 0.43 0.48 0.43 0.48 0.62 0.75 1.85 1.28
Std. Dev. 1.56 1.21 1.40 1.30 1.37 1.48 1.65 1.74 2.01 2.77 2.40
t(Mean) 5.22 4.87 3.82 4.76 5.00 4.18 4.16 5.12 5.34 9.53 7.58
Sharpe R 1.27 1.18 0.93 1.16 1.21 1.01 1.01 1.24 1.29 2.31 1.84
0.13 0.12 0.08 0.03 0.06 -0.02 -0.10 -0.05 0.02 -0.18 -0.31
t() 1.12 1.45 0.74 0.42 0.68 -0.24 -0.98 -0.40 0.18 -0.83 -1.17 0.53 0.86

L
0.68 0.55 0.62 0.65 0.68 0.73 0.84 0.89 1.02 1.41 0.72

S
0.03 0.03 0.06 0.15 0.12 0.14 0.19 0.32 0.29 1.16 1.14

V
0.11 0.01 -0.04 -0.03 0.01 0.00 0.03 -0.02 0.02 0.42 0.30
R
2
0.64 0.69 0.64 0.75 0.76 0.73 0.78 0.72 0.74 0.63 0.24
55
Panel M: Slope of Volatility Term Structure Portfolios (Long)
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
Slope(L) High Low
Mean 0.57 0.37 0.20 0.16 0.14 0.04 0.02 -0.06 -0.03 0.20 -0.37
Std. Dev. 2.32 1.79 1.80 1.79 1.82 2.12 2.13 2.29 2.55 3.01 1.90
t(Mean) 3.54 2.95 1.55 1.29 1.07 0.29 0.10 -0.40 -0.16 0.96 -2.78
Sharpe R 0.86 0.71 0.38 0.31 0.26 0.07 0.03 -0.10 -0.04 0.23 -0.68
0.47 0.38 0.20 0.24 0.12 0.06 -0.22 -0.00 -0.19 -0.31 -0.79
t() 3.51 3.78 2.03 2.64 1.44 0.57 -2.11 -0.03 -1.53 -1.58 -3.46 3.94 0.00

L
0.90 0.69 0.73 0.74 0.78 0.90 0.96 0.96 1.11 1.26 0.37

S
-0.61 -0.52 -0.44 -0.42 -0.39 -0.49 -0.33 -0.48 -0.48 -0.38 0.24

V
0.24 0.13 0.05 -0.06 -0.01 -0.00 0.08 -0.10 0.07 0.29 0.05
R
2
0.78 0.80 0.81 0.84 0.85 0.86 0.85 0.83 0.84 0.72 0.09
Panel N: Open Interest Gamma
Deciles
1 2 3 4 5 6 7 8 9 10 10-1 GRS p(GRS)
OpenGamma Low High
Mean 0.09 0.06 0.17 0.23 0.14 0.21 0.23 0.47 0.62 0.95 0.86
Std. Dev. 1.76 1.78 1.55 1.65 1.82 1.93 2.00 2.03 2.21 2.45 1.73
t(Mean) 0.75 0.48 1.54 1.96 1.08 1.59 1.67 3.30 4.03 5.55 7.11
Sharpe R 0.18 0.12 0.37 0.48 0.26 0.39 0.41 0.80 0.98 1.35 1.72
-0.22 0.04 0.07 0.00 -0.15 0.09 -0.00 0.30 -0.00 0.28 0.50
t() -1.80 0.46 0.85 0.03 -1.57 0.89 -0.01 2.84 -0.00 1.94 2.58 2.03 0.03

L
0.77 0.76 0.67 0.77 0.85 0.85 0.90 0.88 1.04 1.08 0.32

S
-0.09 -0.33 -0.25 -0.17 -0.13 -0.33 -0.29 -0.37 -0.05 -0.22 -0.13

V
0.04 -0.06 0.00 0.02 0.01 0.02 0.08 0.09 0.21 0.40 0.36
R
2
0.70 0.82 0.81 0.86 0.83 0.84 0.84 0.83 0.78 0.77 0.20
VII. Conclusion
I examine the discount-rate variation in individual equity options by studying the excess returns
from selling option portfolios that are leverage-adjusted monthly and delta-hedged daily. I uncover
a puzzling connection between option maturity, risk and expected returns. Dierent measures of
riskreturn volatility, market beta, VIX beta, average returns during price-jump, volatility-jump
episodes and market distressall indicate that long-maturity options are riskier relative to short-
maturity options, yet expected returns are lower for long maturity options.
I identify three new return-based pricing factorslevel, slope, and valuein option returns.
Cross-sectional variation in expected returns on option portfolios formed on moneyness, maturity
and value can be explained by comovements of their excess returns with these three systematic
56
factors. Sensitivities of option portfolios to the level, slope and value factors capture the expected
return variation in the moneyness, maturity and value direction respectively.
The premium on the level factor is compensation for market-wide volatility and jump shocks.
Understanding the slope factor (or maturity premium) is a challenge, because market-wide volatil-
ity and jump risk indicates a negative rather than a positive premium. I argue that the gamma
aversion of market makers and the leverage preference of investors are the main drivers of the pre-
mium on the slope factor. It is likewise dicult to explain the value factor, because it has almost
no correlation with contemporaneous innovations in VIX and overall it tends to perform better
during jump episodes. I argue that the premium on value factor is related to variance risk premia
and demand pressure. Theories of risk averse nancial intermediaries such as the demand-based
option pricing model of Garleanu, Pedersen, and Poteshman (2009), help us to understand the
slope and value premiums. Consistent with the friction-based interpretation, the premiums on the
slope and value factors are higher when funding liquidity conditions are tight.
I explore three new option investment strategiesopen interest gamma, option carry and
volatility reversalswhich are successful at generating statistically signicant returns with high
Sharpe ratios. Previous researchers document that expected returns on options are related to
variance risk premia, idiosyncratic volatility, stock short-term reversal, stock size, stock illiquidity,
option illiquidity, embedded leverage and slope of volatility term structure. My three-factor model
helps explain all of these patterns.
57
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60
A.I. Additional Empirical Results and Robustness Tests
In this section, I consider a series of robustness checks to show the empirical success of the option
three-factor model. First of all, I test the option three-factor model on the thirty moneyness-
maturity portfolios and the decile value portfolios in 6 additional sub-samples. Table A.1 reports
mean absolute average returns, MAE and GRS statistics with their p-values and average R
2
from
multiple time-series regressions. The results are promising. Excluding the 1996-1999 sample,
the option three-factor model actually performs better than original results both for moneyness-
maturity and value portfolios. While the GRS test rejects the option three-factor model on
moneyness-maturity portfolios in the full sample, it fails to reject in sub-samples excluding the
1996-1999. For example in the 2006-2012 sample p-value of GRS is 0.27, in the 2000-2012 sample
p-value is more than 0.07. MAE test also do not reject the model in any sub-sample except
the 1996-1999. In the full sample, GRS or MAE fail to reject the option three-factor model on
value portfolios. Both of the test statistics fail to reject the model in all the sub-samples that
I considered except the 1996-1999. We should not give much attention to the 1996-1999 period,
because trading volume in the option market was very low. In market value trading volume was
lower than 200 billion dollars. Nowadays trading volume is about 1.5 trillion dollars. Moreover
option price data before 2002 is less reliable, because the data vendor Optionmetrics was launch
in 2002, since then they have been daily collecting dealers end-of-day quotes directly from the
U.S. Exchanges. They collect the data on the earlier period from the market-makers.
Table A.1: Robustness Analysis: Asset Pricing Tests in Sub-Samples
This table reports the results of asset pricing tests of option three-factor model using two groups of dependent
portfolios and dierent sub-samples. Dependent portfolios are the decile value portfolios and the thirty
moneyness-maturity portfolios. Sub-sample periods are 1996-1999, 2000-2005, 2006-2009, 2010-2012, 2006-
2012. I also report the results of full sample 1996-2012 for comparison. Ave |Rx| is the average of absolute
excess returns of dependent portfolios. MAE is mean absolute pricing errors (average ||). GRS is the
F-statistics of Gibbons, Ross, and Shanken (1989) testing the null hypothesis of all s are jointly equal to
zero. p(GRS) and p(MAE) are the p-values of GRS and MAE statistics. I run OLS with 10,000 bootstrap
simulations under the null hypothesis of zero pricing errors to estimate t-statistics and p-value.
L
,
S
,
V
are slope coecients of the level, slope, value factors respectively. R
e
i,t
is excess return on portfolio i at time
t. The sample covers 204 months from January 1996 to January 2013.
R
e
i,t
=
i
+
L
i
Level
t
+
s
i
Slope
t
+
v
i
V alue
t
+
i,t
i {1, 2, ..., 10}
Dependent Portfolios Period Ave |R
e
| (bps) MAE (bps) p(MAE) GRS p(GRS) Ave R
2
30 moneyness-maturity 1996-1999 42 36 0.0035 2.32 0.3554 0.66
30 moneyness-maturity 2000-2005 54 19 0.4479 1.86 0.0722 0.63
30 moneyness-maturity 2006-2009 51 28 0.1687 0.92 0.8202 0.82
30 moneyness-maturity 2010-2012 84 27 0.1233 0.56 0.1154 0.81
30 moneyness-maturity 2006-2012 64 20 0.1663 1.19 0.2790 0.81
30 moneyness-maturity 2000-2012 59 17 0.1309 1.54 0.0418 0.74
30 moneyness-maturity 1996-2012 44 15 0.1037 1.95 0.0032 0.73
10 Value 1996-1999 41 31 0.0001 2.22 0.0309 0.78
10 Value 2000-2005 47 7 0.8703 0.63 0.6575 0.85
10 Value 2006-2009 30 19 0.1565 1.58 0.0960 0.94
10 Value 2010-2012 71 11 0.5170 0.51 0.7535 0.94
10 Value 2006-2012 47 13 0.1679 2.18 0.0151 0.94
10 Value 2000-2012 46 8 0.2877 0.88 0.4326 0.91
10 Value 1996-2012 38 10 0.0777 1.15 0.2428 0.90
1
As an additional robustness check, I report leverage-unadjusted returns on the thirty moneyness-
maturity portfolios in the appendix. I nd that the option three-factor model does decent job at
explaining leverage-unadjusted returns as well. The model explains more than half of the aver-
age return variation. I also build the thirty moneyness-maturity portfolios just for call and put
options. The model does well in explaining the return on those portfolios too. To save space, I
report the results in the web appendix.
Table A.2: Alternative Return Calculations
This table reports summary statistics of unlevered returns on selling option portfolios across moneyness-
maturity groups. At each month, Saturday following the 3rd Friday of the month is standard expiration
date. Each month, at the rst trading day following the expiration date, I assign options into thirty portfolios
based on ve moneyness (absolute value of delta) and six maturity (months to expiration) groups. Moneyness
groups are DOTM (deep out of the money, 0 || < 0.20), OTM (out of the money, 0.20 || < 0.40),
ATM (at the money, 0.40 || < 0.60), ITM (in the money, 0.60 || < 0.80), DITM (deep in the money,
0.80 || < 1). Maturity groups are 1, 2, 3, 4 to 6, 7 to 12, greater than 12 months (holding periods).
I keep the option positions till the next expiration date. Panel A, B and C considers alternative return
calculations. Panel A reports summary statistics of excess option returns that are delta-hedged daily, but
unadjusted for leverage. Panel B and C report excess option returns that are unhedged and unadjusted for
leverage. I calculate portfolio excess returns by taking option market capital weighted average return of each
option in a given portfolio, where option market capital is open interest times mid price. I report means,
standard deviations, t-statistics, annualized Sharpe ratios, skewness and kurtosis of portfolio excess returns.
The sample covers 204 months from January 1996 to January 2013.
Moneyness Maturity
1 2 3 4:6 7:12 > 12 1 2 3 4:6 7:12 >12
Excess Returns (Unadjusted for Leverage)
Mean Standard Deviation
DOTM 25.85 8.80 3.89 0.55 -0.05 -0.93 35.73 38.43 30.81 27.26 21.81 15.54
OTM 19.02 7.61 3.18 0.95 0.27 0.11 21.10 19.73 16.53 13.93 11.98 8.86
ATM 11.72 4.58 1.14 0.30 -0.01 0.43 13.52 10.75 9.37 8.05 7.46 5.58
ITM 6.14 1.97 0.94 0.23 0.02 0.17 6.62 5.89 4.73 4.27 4.37 3.26
DITM 2.52 0.86 0.34 0.02 -0.03 0.03 5.20 3.90 3.35 2.45 2.97 2.22
Excess Returns (Unadjusted for Leverage,Unhedged,Call)
Mean Standard Deviation
DOTM -14.23 -6.45 -11.48 -4.79 -5.04 -1.11 98.97 67.51 63.70 46.09 47.04 30.20
OTM -9.43 -2.19 -5.21 -2.14 -2.31 -1.77 80.43 56.71 47.06 36.34 31.19 23.53
ATM -8.67 -2.02 -3.67 -3.05 -2.18 -1.49 64.99 46.92 38.92 31.38 26.28 18.90
ITM -3.88 -1.32 -2.23 -2.64 -2.08 -1.57 49.36 36.62 30.08 25.61 21.99 16.28
DITM -3.59 -2.15 -2.55 -1.29 -1.14 -1.39 37.60 29.10 23.09 21.41 17.64 13.77
Excess Returns (Unadjusted for Leverage,Unhedged,Put)
Mean Standard Deviation
DOTM 7.91 1.78 4.70 0.95 0.18 0.30 107.41 94.58 70.32 58.29 45.92 28.41
OTM 10.20 6.14 5.32 3.31 2.26 1.43 89.43 67.69 53.82 41.76 32.41 20.74
ATM 6.96 4.65 3.53 2.96 1.78 1.17 68.71 49.50 41.00 31.71 26.16 16.82
ITM 4.34 2.65 3.21 2.08 2.02 1.52 49.89 37.91 29.55 23.31 19.45 13.60
DITM 3.98 4.43 3.79 3.35 3.00 0.25 40.02 31.66 28.76 21.89 19.36 11.97
2
Table A.3: Asset Pricing Test of OPT3 (Leverage-Unadjusted Returns)
This table reports the results of multiple regressions and asset pricing tests. I test the option three-factor
model on excess returns (delta hedged, leverage unadjusted) of the thirty portfolios formed on ve moneyness
and six maturity groups. I report s, slope coecients, t-statistics and R-squares. GRS is the joint test
of all pricing errors. I run OLS with 10,000 bootstrap simulations under the null hypothesis of zero pricing
errors to estimate t-statistics and p-values.
L
,
S
,
V
are factor sensitivities of the level, slope, value
factors respectively. The sample covers 204 months from January 1996 to January 2013.
R
e
i,j,t
=
i,j
+
L
i,j
Level
t
+
s
i,j
Slope
t
+
v
i,j
V alue
t
+
i,j,t
i {DOTM, OTM, ATM, ITM, DITM} j {1M, 2M, 3M, 4 : 6M, 7 : 12M, > 12M}
Moneyness Maturity
1 2 3 4:6 7:12 >12 1 2 3 4:6 7:12 >12
t()
DOTM 10.37 -2.67 -2.16 -1.29 0.57 -1.42 3.45 -0.88 -0.94 -0.79 0.41 -1.64
OTM 10.83 2.42 0.37 0.53 0.80 0.43 7.32 1.80 0.40 0.82 1.29 0.93
ATM 4.72 1.40 -0.35 -0.05 -0.43 0.72 5.01 2.08 -0.65 -0.13 -1.23 2.36
ITM 2.93 -0.02 -0.02 -0.03 0.18 0.33 5.15 -0.03 -0.07 -0.12 0.64 1.62
DITM 0.63 -0.44 -0.25 -0.16 -0.13 0.12 1.08 -1.12 -0.79 -0.73 -0.45 0.54

M
t(
M
)
DOTM 16.95 17.18 13.21 11.60 8.10 6.29 14.91 14.70 15.08 18.63 15.14 19.17
OTM 10.95 9.56 7.74 6.06 4.68 3.42 19.18 18.69 21.56 24.28 19.68 19.58
ATM 7.36 5.45 4.35 3.59 3.29 2.14 20.07 21.31 21.19 25.61 24.63 18.70
ITM 3.18 2.68 2.10 1.83 1.65 1.24 14.70 14.96 15.58 19.80 15.74 16.03
DITM 1.60 1.46 1.24 0.84 0.89 0.58 7.10 9.79 10.12 9.92 8.18 7.14

T
t(
T
)
DOTM 10.12 3.74 -0.92 -4.18 -5.97 -3.73 4.36 1.57 -0.52 -3.33 -5.48 -5.54
OTM 5.90 2.19 -0.79 -2.85 -3.53 -2.73 5.13 2.09 -1.09 -5.68 -7.24 -7.64
ATM 6.05 1.48 -0.54 -1.45 -1.42 -1.65 8.28 2.85 -1.29 -5.13 -5.17 -6.96
ITM 2.46 0.69 0.09 -0.73 -1.11 -0.81 5.54 1.93 0.31 -3.90 -5.13 -5.10
DITM 1.52 0.83 0.19 -0.25 -0.47 -0.49 3.34 2.75 0.77 -1.45 -2.10 -2.93

V
t(
V
)
DOTM -1.07 0.40 0.84 0.10 0.85 0.87 -0.76 0.28 0.79 0.13 1.30 2.13
OTM -2.08 -1.18 -0.08 0.08 0.37 0.48 -3.00 -1.91 -0.17 0.28 1.25 2.25
ATM -1.72 -0.65 -0.05 -0.07 0.14 0.15 -3.83 -2.10 -0.21 -0.38 0.84 1.06
ITM -0.39 0.18 -0.07 0.04 0.03 -0.04 -1.47 0.84 -0.46 0.36 0.23 -0.41
DITM -0.15 -0.10 -0.15 0.01 0.09 0.08 -0.56 -0.51 -0.99 0.06 0.69 0.77
Adj R-square GRS (p-val)
DOTM 0.55 0.59 0.65 0.77 0.74 0.80 7.65 (0.0000)
OTM 0.69 0.70 0.79 0.86 0.83 0.83
ATM 0.68 0.75 0.79 0.87 0.86 0.81
ITM 0.53 0.60 0.65 0.79 0.74 0.75
DITM 0.19 0.34 0.42 0.48 0.41 0.39
3
Table A.4: Correlation Matrix
This table reports 100 times correlation coecients for several characteristic-based trading strategies. Strate-
gies are 10-1 decile portfolio returns except the level, slope and value factors. The sample covers 204 months
from January 1996 to January 2013.
100 Correlation
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Level
Slope -62
Value -4 16
Carry 67 -15 16
VRP -2 7 22 -8
Vol.Mom. -21 34 27 -3 15
Sys.Vol. 53 -31 -12 66 -32 -25
Idio.Vol. 57 -30 1 61 -14 -17 62
S.Rev. 33 -18 9 33 -1 17 20 25
Size 23 0 17 42 -10 -2 30 25 22
S.Illiq 5 2 18 20 7 -7 17 25 3 44
O.Illiq. 65 -35 17 60 -13 -29 46 37 33 44 21
E.Lev.(1) 73 -33 -4 43 -1 -22 29 24 20 19 10 69
E.Lev.(2) 71 -48 14 73 -4 -26 61 72 40 25 17 50 30
Vol.Slope(S) 28 12 20 58 5 14 35 47 26 18 16 16 2 48
Vol.Slope(L) -29 9 -4 -41 -4 -6 -36 -40 -31 -7 -10 -17 -8 -46 -47
O.Gamma 37 -24 22 47 2 -4 28 47 37 44 33 40 20 60 32 -28
Table A.5: Regression Results
This table reports the results from multiple time-series regressions. Independent variables are the level, slope
and value factors at time t. The dependent variables are Ted Spread (change in Ted spread from time
t-1 to t), lag Ted spread (at time t-1), lag Ted Spread Vol (standard deviation of daily Ted spreads in the
previous holding period from t-2 to t-1) and Ted Spread Vol ( change in the holding period standard
deviation of Ted spread from t-1 to t). I bootstrap 10,000 samples under the null of zero predictability to
calculate t-statistics. The sample covers 204 months from January 1996 to January 2013.
Level (bps) Slope (bps) Value (bps)
(1) (2) (3) (4) (5) (6)
Ted Spread -2.12 0.68 -0.51
t( Ted Spread) (-2.66) (1.92) (-1.49)
Lag Ted Spread -1.82 0.64 0.53
t(Lag Ted Spread) (-2.68) (2.10) (2.07)
Ted Spread Vol -9.73 2.32 -0.66
t( Ted Spread Vol) (-4.84) (2.60) (-0.50)
Lag Ted Spread Vol -9.12 3.94 2.47
t(Lag Ted Spread Vol) (-2.57) (2.77) (1.93)
VIX 5.01 4.32 -0.44 -0.70 2.24 2.58
t(VIX) (2.27) (1.88) (-0.42) (-0.68) (1.89) (2.24)
Adj R
2
0.18 0.20 0.07 0.10 0.12 0.11
4