Money Managers Should Include Option Momentum Strategy to Deliver More Outperformance

LSU Department of Finance Associate Professor Haitao Mo and PhD student Mehdi Khorram, along with three other co-authors, analyzed momentum strategy in the stock options market in their recent paper titled "Option Momentum," which was accepted and is forthcoming in the Journal of Finance, the top journal in the finance and economics disciplines.

In their study, the authors found that price momentum strategy not only works in the stock options market, but also is several times stronger in offering risk-adjusted returns than in stock markets, before incorporating transaction costs. For example, it offers an annualized Sharpe ratio of 1.53 when one computes momentum signals using the past year. Further, it has little crash risk, remains profitable under reasonable assumptions of transaction costs or if the strategy is modified to reduce the effects of those costs, and is completely distinct from the price momentum phenomenon in the stock markets.

“Option momentum strategy, which buys past winning stock options and sells past losing stock options, can be very profitable, especially when investors take measures to diminish transaction costs. Since the performance of the strategy has little correlation with that of a typical stock strategy, money managers can consider adding option momentum strategy to their portfolios to deliver more outperformance and better diversification. Our findings also speak to the potential price inefficiency in the options market and should encourage investors to look for more opportunities in this market, “explained Mo.

Price momentum, the tendency for an asset to continue its past price movement in the future, has been one of the most robust drivers of excess returns in stock markets. It is one of the popular factor styles the asset management industry actively pursues to deliver outperformance, via either factor index funds and ETFs or portfolio tilting. While price momentum strategy, which buys assets with past price increases and sells assets with past price decreases, becomes common when investing in stocks, academics and practitioners haven’t uncovered much information about whether and how well price momentum strategy works when investing in the stock options markets.

The answer is not necessarily straightforward given drastic differences between stock and options markets. First, since stock options are exposed to the movements of underlying stocks, any strategy applied to stock options markets always hedges out the impact of underlying stocks. As a result, option price momentum strategy is protected from stock price movements and cannot work mechanically due to stock price momentum phenomenon. Second, unlike stock markets, stock options markets are more of a place for investors to bet on stock volatility. For example, investors believing in a future stock volatility increase would buy options (call or put) to profit from that belief. Third, due to their much lower prices, options require less capital than stocks to make the same number of risky bets. Such embedded leverages may also influence the efficacy of any strategy that is transplanted from stock markets.

 

About the Journal of Finance

The Journal of Finance publishes leading research across all the major fields of financial research. It is the most widely cited academic journal on finance. Each issue of the journal reaches over 8,000 academics, finance professionals, libraries, government, and financial institutions around the world. Published six times a year, the journal is the official publication of The American Finance Association, the premier academic organization devoted to the study and promotion of knowledge about financial economics. 

 

About the Department of Finance

The Department of Finance offers high-quality curricula to undergraduate and graduate students interested in careers in corporate finance, asset management, real estate, insurance, banking, financial planning, and business law. The department boasts internationally renowned research faculty in several areas, including derivatives, asset management, banking, and spatial econometrics. The department’s Securities Markets Analysis Research & Trading Lab utilizes the Bloomberg Professional service, the platform used by more than 300,000 leading business and financial professionals worldwide to make informed business decisions, and an extensive library of financial databases including the Wharton WRDS System. Additionally, the department encourages, supports, and conducts research in real estate by housing the nationally renowned Real Estate Research Institute. For more information, visit lsu.edu/business/finance or call 225-578-6291.

 

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