Publication

The Variance Premium and Seasonal Momentum in Option Returns, with Steven Heston, Christopher Jones, Mehdi Khorram, and Haitao Mo

Accepted at the Review of Financial Studies

Option Momentum, 2023, with Steven Heston, Christopher Jones, Mehdi Khorram, and Haitao Mo

Journal of Finance, Volume 78, Issue 6, Pages 3141-3192

This paper combines two working papers ``Option Momentum'' by Heston and Li, and ``Momentum, Reversal, and Seasonality in Option Returns'' by Jones, Khorram, and Mo.
Link to the working paper version [SSRN]

Working Papers:

2025 FMA Conference on Derivatives and Volatility (scheduled), 2025 New Zealand Finance Meeting (scheduled).

We propose novel firm-level measures for subjective expectations on variance and skewness derived from analysts' price forecast ranges in their research reports. We find that analyst expectations positively predict future variance and skewness of stock return, even after controlling for corresponding option-implied moments and past realized moments. Moreover, analyst variance (skewness) expectation positively predicts returns on straddle (skewness asset) and generates a profitable option strategy with an annualized Sharpe ratio of 0.93 (1.27). Using the same analyst's expectations for return, variance, and skewness, we uncover a positive subjective risk-return trade-off and a negative skewness-return trade-off that are consistent with classical finance theories. To examine the formation of analyst expectations, we employ large language models to identify key topics from analysts' discussions and apply machine learning techniques to quantify their impacts. Bankruptcy, government debt, and commodities play a crucial role in shaping analysts' variance expectations, while earnings losses, bank loans, and business cycles are the dominant drivers of their skewness expectations. We find strong interaction effects between narratives and option-implied and realized moments in shaping analysts' risk perceptions.

(2024 FMA Best Paper Award in Options & Derivatives)

We examine how hedge fund option demand influences the skewness risk premium. Fund demand for put options positively predicts cross-sectional returns of skewness assets constructed from individual stock options. This return predictability concentrates on options with high hedging costs and stems from long naked put positions but not protective puts or straddles. We provide evidence that hedge fund speculative demand for firm-specific downside risk creates demand pressure on out-of-the-money put options, resulting in lower prices and higher future returns for skewness assets. Long naked put positions do not predict realized skewness, and are associated with fund underperformance during COVID-19.

We document option momentum spillovers across peer firms with shared analyst coverage. Firms whose peers have higher past-12-month delta-hedged straddle returns tend to have higher future option returns. Peer option momentum has a magnitude similar to the option momentum documented by Heston et al. (2023), but it is distinct from option momentum. Past option returns of a firm's peers can predict the firm's realized variance even after we control the firm's option-implied variance and its own past option returns. In addition, peer momentum is stronger for indirect linkages. The findings are consistent with limited investor attention on volatility information from peer firms. Compared with peer stock momentum, peer option momentum persists longer and exhibits spillovers via more economic linkages that cannot be subsumed by analyst-based linkages.