Options Trading with Cross-Sectional Volatility Factors

The article “Options Trading with Cross-Sectional Volatility Factors” was originally posted on Robot Wealth blog.

A few years ago, I got deep into the idea of constructing a long/short equity options portfolio based on the kind of simple factor sorts that had been so successful in quant equity.

My original intention was to set up an index and license it to fund managers.

Of course, there are many reasons why this is a very hard business problem – so I never really got off the ground with it. But I do keep these factors in the back of my mind when I am trading options:

• Value Factor – Options on value stocks tend to be overpriced relative to growth stocks. Short options on value stocks has produced significantly positive returns, independent of the value effect.
• Size Factor – Small-cap options tend to have overpriced volatility.
• Idiosyncratic Vol Factor – Options on stocks with high idiosyncratic volatility tend to be overpriced / options on stocks with low idiosyncratic volatility tend to be underpriced.
• Beta Convexity Factor – Options on stocks with convex betas to the index tend to be underpriced (high downside beta / low upside beta). Paul Wilmott uses this in his “Platinum Hedging” Riskmetrics VAR model.
• IV Term Structure Factor – Options for which shorter-term IV is greater than longer-term IV tend to be underpriced. Options where shorter-term IV is less than longer-term IV tend to be overpriced.
• IV Premium Factor – Options with the lowest difference between historical realised and implied volatility tend to be underpriced. Options with large differences tend to be overpriced. This used to be an extremely effective factor – but this hasn’t been the case for a while.
• Momentum Volatility Factor – Options on stocks with high absolute momentum tend to be underpriced. Options on stocks with low absolute momentum tend be overpriced.

Source Papers

• Ammann, Skovmand, Verhofen – Implied and Realized Volatility in the Cross-Section of Equity Options
• Cao, Han – Cross-Section of Option Returns and Idiosyncratic Stock Volatility
• Vasquez – Equity Volatility Term Structures and the Cross-Section of Option Returns
• Goyal, Saretto – Option Returns and Volatility Mispricing

A Word of Caution

Be aware that the “cross-section of options returns” literature tends to make these effects look much juicier than they really are because:

• they don’t tend to model the margin you need to hold on your shorts
• they tend to assume midpoint execution, which is optimistic for less liquid options.