September 16, 2019
In the data, out-of-the-money (OTM) S&P 500 call and put options both have puzzling low average returns. Existing studies relate these results to models with non-standard preferences. We argue that the low returns on OTM index options are primarily due to the pricing of market volatility risk. When volatility risk is priced, expected option returns match the average returns of call and put options across all strikes as well as returns of option portfolios.