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J. Yoo: The factor structure of short maturity options

March 7, 2025

Equity index options with less than one month to maturity have surged in popularity over the past two decades, particularly for the very shortest maturities. S&P 500 (SPX) options with fewer than 10 days to maturity represented 17% of all SPX option trading volume in 1996 as compared to around 70% today. Despite this popularity, research on such short maturities remains limited. In this paper, I examine deleveraged daily returns to short maturity contracts written on three major U.S. indices: S&P 500, Nasdaq 100, and Russell 2000. I estimate Instrumental Principal Components Analysis factor models and find evidence for a low-dimensional factor structure that explains over 95% of the variation in the cross-section of option returns. I apply two complementary approaches to interpret the latent factors and conclude they primarily provide compensation for exposure to the forward-looking higher-order moments of these indices, namely risk-neutral variance and skewness. Based on this interpretation, I propose a tradable factor model which outperforms previously proposed models from the literature and industry practice. Using this factor model, I quantify the contributions to the expected return for options with various levels of moneyness, maturity, and type (call/put) from exposure to the underlying index, variance, and skewness. I document substantial contributions to the expected return from exposure to these higher-order moments, with significant variation across moneyness, maturity and type.

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