Research Insights: Weighing your options

Investors in the stock market are always looking for a competitive edge. One such advantage, involving options trading, has been uncovered by a Saunders College faculty member, working with colleagues elsewhere.

Mehdi Khorram, Ph.D., assistant professor of finance in Saunders College, is co-author of an article, “Option Momentum,” forthcoming in the Journal of Finance, the premier journal in the field. 

Momentum is the tendency for assets—for example, stocks, corporate bonds, commodities—that have earned above-average returns in the past to continue to outperform in the future. Khorram and his co-authors focused their attention on options. They obtained call (the right to buy a stock) and put (the right to sell a stock) prices from the OptionMetrics database, which provides end-of-day bid-ask quotes for options traded on U.S. exchanges, for options traded on U.S. exchanges from January 1996 to June 2019. Then, they computed monthly returns on at-the-money straddles (a position with both a call and put with the same strike price and expiration date) on individual equities. 

The authors found that options with high historical returns continue to significantly outperform options with low historical returns over horizons ranging from six to 36 months. Momentum was present whether they measured past performance on a relative basis (\cross-sectional momentum") or an absolute basis (\time series momentum"). Surprisingly, a zero-investment strategy based on momentum—buying past winning equity options and selling past losing options—generated a monthly return of about six percent. Also, unlike stock momentum, option return continuation is not followed by long-run reversal, which is in sharp contrast with the behavior of stocks.

Khorram’s article has several important implications. First, the results uncover the potential market inefficiency in the options market, so investors are encouraged to seek out opportunities here. Second, money managers should consider adding an option momentum strategy to their portfolios. And third, the options market is a place for investors to bet on market volatility. Identifying trading patterns such as momentum can help regulators and researchers understand investors’ beliefs on future market volatility.

View the article forthcoming in the Journal of Finance, “Option Momentum”.