Momentum in the Option Market, Part 2

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Momentum is a widely observed phenomenon in the stock market that refers to the tendency of stocks that have exhibited strong price performance in the past to continue performing well in the future, and vice versa. The momentum effect suggests that stocks experiencing upward price trends tend to attract further buying interest, leading to additional price increases, while stocks on a downward trend tend to experience continued selling pressure, resulting in further price declines. This phenomenon is often attributed to various factors, including investor psychology, market trends, and herding behavior.

Momentum is not limited to the equity market alone; it also manifests in the option market. As we have previously discussed, delta-hedged straddle option positions have shown evidence of exhibiting momentum. Recently, in Reference [1], further research has delved into exploring momentum within the option market by extending the analysis to include option factors. The authors pointed out,

In this paper, we extend tests for factor momentum to the options markets, relying on a novel set of 56 factors based on sorts of daily delta-hedged call options. We find corroborating evidence for both the existence of factor momentum and its explanatory power for momentum in the factors’ underlying assets: First, time-series and cross-sectional factor momentum strategies are profitable. Their returns are distinct from returns of an equally-weighted factor portfolio and robust to the factor model of Horenstein et al. (2020). Second, strategies relying on a one-month formation period are largely driven by factor autocorrelation. However, the longer the formation period, the more important are high mean factor returns and their persistent variation as momentum drivers. Third, as in Ehsani & Linnainmaa (2022) and Arnott et al. (2023), momentum effects are the strongest in the option factors’ largest eigenvalue principal components. Fourth, and extending the findings in Heston et al. (2022) to single option returns, we find momentum at the option level. Spanning tests suggest that option factor momentum subsumes option momentum and not vice versa.

This study presents additional insights into how momentum can influence options. By understanding and harnessing momentum in the option market, investors can potentially enhance their trading strategies and optimize their risk-return profiles.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Käfer, Niclas and Moerke, Mathis and Wiest, Tobias, Option Factor Momentum (2023), https://ssrn.com/abstract=4405852

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