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

  • José Afonso Faias and Pedro 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.

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Copyright
Corresponding author
* Faias (corresponding author), jfaias@ucp.pt, UCP–Católica Lisbon School of Business & Economics; Santa-Clara, psc@novasbe.pt, Nova School of Business and Economics, NBER, and CEPR.
Footnotes
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1 We thank Hendrik Bessembinder (the editor) and Peter Christoffersen (the referee) for valuable comments that significantly improved the paper. We also thank Rui Albuquerque, Pierre Collin-Dufresne, Joost Driessen, Miguel Ferreira, Mark Grinblatt, José Correia Guedes, Christopher Jones, Ángel León, André Lucas, Pedro Matos, David Moreno, Andreas Rathgeber, Enrique Sentana, Ivan Shaliastovich, and 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, the Finance & Economics 2010 conference, the 2010 Foro de Finanzas, the 2011 American Finance Association annual meeting, the 2011 Professional Asset Management conference, the Oxford-Man Institute at Quantitative Finance, the 2011 EFMA annual meeting, the EcoMod2011, the conference in honor of Richard Roll and Eduardo Schwartz, the 2011 Swissquote conference, the 2011 conference on Advances in the Analysis of Hedge Fund Strategies, the Boston University, and the Research in Options conference for helpful comments and discussions. This research was funded by grant PTDC/EGE-ECO/119683/2010 from the Portuguese Foundation for Science and Technology–FCT.
Footnotes
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