Do options of individual stocks exhibit momentum and seasonality patterns? In their November 2020 paper entitled “Momentum, Reversal, and Seasonality in Option Returns”, Christopher Jones, Mehdi Khorram and Haitao Mo investigate momentum and seasonality effects for options on U.S. common stocks. They focus on performance of straddles, combining a put and a call with the same strike price and expiration date. They balance needs for liquidity and sample size by requiring positive open interest during the holding period but not the momentum calculation interval. Specifically, on each monthly option expiration date, they:
- Form two straddles from near-the-money options expiring next month for each for each stock: (1) the pair with call delta closest to 0.5 for calculating momentum; and, (2) the pair with call delta closest to 0.5 and with positive open interest for both the put and the call when selected for calculating momentum portfolio return.
- Construct from these pairs zero-delta straddles using bid-ask midpoints as prices and calculate monthly straddle excess returns relative to the 1-month Treasury bill yield. This process generates about 1,600 straddles per month with average monthly excess return -5.6% and very large standard deviations.
- Calculate momentum as average monthly excess return over a specified lookback interval (rather than cumulative return, to suppress effects of return outliers).
- Rank straddle returns into equal-weighted fifths (quintiles) based on momentum and calculate average return for each quintile and for a portfolio that is long the top quintile and short the bottom quintile.
Using end-of-day open interest and bid-ask quotes for call and put options on U.S. common stocks from OptionMetric and trading data for underlying stocks during January 1996 through June 2019, they find that:
- For a 1-month lookback interval, straddle returns significantly reverse next month, more strongly than do stock returns.
- Momentum is much stronger for options than for other asset classes on a gross basis, with Sharpe ratios at least three times higher than that for stocks. Option returns display substantial momentum using lookback intervals of 6 to 36 months long, with highest average gross monthly return for 12 months (6.6%).
- Relatively strong straddle series past performance for lags that are multiples of 3 or 12 months predicts significantly strong relative performance the current month.
- Maximum drawdowns for reversal, momentum and seasonality are modest compared to their mean returns and to drawdowns of alternative option strategies.
- Results are robust to controlling for firm characteristics including size, stock or option liquidity, analyst coverage and credit rating. Momentum and seasonality survive factor risk adjustment.
- All three effects are stable over the sample period. Momentum is significant every year, and seasonality nearly achieves this persistence.
- Option momentum is mainly due to underreaction to past volatility spikes, while seasonality derives from unpriced seasonal variation in volatility.
In summary, evidence indicates that gross returns for options on U.S. common stocks exhibit significant short-term reversal, intermediate-term momentum and quarterly/annual cycles.
Cautions regarding findings include:
- Performance data are gross, not net. Options have relatively wide bid-ask spreads and therefore high trading frictions, which would reduce reported returns. Options also generally involve broker fees, and data for option strategies is often not free.
- The methodology described is beyond the reach of most investors, who would bear fees for delegating to a fund manager.
- While maximum drawdowns for the three strategies are lower than those of reasonable benchmarks, they are still substantial. For example, maximum drawdown for the momentum strategy is -46%, while that for reversal is -69% and those for seasonality alternatives are around -40%.
