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J. Faias, P. Santa-Clara, “Optimal Option Portfolio Strategies: Deepening the Puzzle of Index Option Mispricing”

J. Faias, P. Santa-Clara, “Optimal Option Portfolio Strategies: Deepening the Puzzle of Index Option Mispricing”

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.