Why Do Option Returns Change Sign from Day to Night?
Boston College - Carroll School of Management
...MORE (60 page PDF)The risk-premium embedded in S&P 500 index options is negative and large: delta-hedged returns for these options are -0.7% per day. Strikingly, this risk premium is driven purely by negative overnight option returns: When we decompose this premium into intraday (open-to-close) and overnight (close-to-open) components, we find that average overnight returns are -1% while intraday returns are actually positive, 0.3% per day. Similar return pattern holds across option types, maturities, and moneyness, as well as for equity and ETF options, and VIX futures. Conventional risk-based theories cannot explain the positive intraday returns. However, we show that option returns become positive intraday because option investors ignore the well-known fact that stock volatility is substantially higher intraday than overnight. Thus, option prices apparently fail to properly reflect perhaps the strongest volatility seasonality, suggesting that option market-makers are less rational than previously thought. Finally, other option investors appear also unaware of this anomaly, which may explain its persistence.