May 8, 2008
We study the partial equilibrium portfolio optimization problem for a myopic CRRA investor who can trade options on individual stocks. Applying the parametric portfolio approach of Brandt, Santa-Clara, and Valkanov (forthcoming) to derivatives, we show that options characteristics (such as implied volatility and IV smile skew) convey information about the mispricing in the option portfolios. We take the data on all US-traded options to build characteristic-based factor portfolios of options. An investor uses them in addition to the market portfolio and Fama and French (1992) factors in her utility maximization.