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Journal of Financial and Quantitative Analysis Vol. 52 No. 1 2017

Optimal Option Portfolio Strategies: Deepening the Puzzle of Index Option Mispricing

José Afonso Faias1,2; Pedro Santa-Clara

1 participants at Nova School of Business and Economics, the Quantitative Economics Doctorate 2010 meeting at Alicante, Católica Lisbon School of Business & Economics, the 2010 Portuguese Finance Network conference, · 2 UCP-Católica Lisbon School of Business & Eco-nomics; Santa-Clara,

Abstract

Traditional methods of asset allocation (such as mean–variance optimization) are not adequate for option portfolios because the distribution of returns is non-normal and the short sample of option returns available makes it difficult to estimate their distribution. We propose a method to optimize a portfolio of European options, held to maturity, with a myopic objective function that overcomes these limitations. In an out-of-sample exercise incorporating realistic transaction costs, the portfolio strategy delivers a Sharpe ratio of 0.82 with positive skewness. This performance is mostly obtained by exploiting mispricing between options and not by loading on jump or volatility risk premia.

DOI
10.1017/s0022109016000831
Volume
52
Issue
1
Pages
277-303
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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