2 Santa-Clara

Optimal Option Portfolio Strategies∗
José Afonso Faias1 and Pedro Santa-Clara2
Current version: October 2011
Abstract
Options should play an important role in asset allocation. They allow for kernel span-
ning and provide access to additional (priced) risk factors such as stochastic volatility
and negative jumps. Unfortunately, the traditional methods of asset allocation (such
as mean-variance optimization) are not adequate for considering options because the
distribution of returns is non-normal, and the short sample of option returns avail-
able makes it difficult to estimate the distribution. We propose a method to optimize
option portfolios that solves these limitations. In an out-of-sample exercise, even
when transaction costs are incorporated, the portfolio strategy delivers an annualized
Sharpe ratio of 0.50 between January 1996 and October 2010.
∗
Corresponding author: José Afonso Faias, Universidade Católica Portuguesa - Católica Lisbon School
of Business and Economics, Palma de Cima, 1649-023 Lisboa, Portugal. E-mail: jfaias@clsbe.lisboa.ucp.pt.
We thank Joost Driessen, Miguel Ferreira, Mark Grinblatt, José Correia Guedes, Christopher Jones, Ángel
León, André Lucas, Pedro Matos, David Moreno, Andreas Rathgeber, Enrique Sentana, Ivan Shaliastovich,
and participants at the Informal Research Workshop at Universidade Nova de Lisboa, the QED 2010
Meeting at Alicante, Universidade Católica Portuguesa, the 6th Portuguese Finance Network Conference,
the Finance & Economics 2010 Conference, the XVIII Foro de Finanzas, the 2011 AFA Annual Meeting,
the 5th Conference on Professional Asset Management, the Oxford–Man Institute at Quantitative Finance,
the 2011 EFMA Annual Meeting, the EcoMod2011, and the Conference in honor of Richard Roll and
Eduardo Schwartz for helpful comments and discussions. This research was funded by grant PTDC/EGE-
ECO/119683/2010 of the Portuguese Foundation for Science and Technology-FCT.
1
Universidade Católica Portuguesa - Católica Lisbon School of Business and Economics, Palma de Cima,
1649-023 Lisboa, Portugal. Phone +351-21-7270250. E-mail: jfaias@clsbe.lisboa.ucp.pt.
2
Millennium Chair in Finance. Universidade Nova de Lisboa - NOVA School of Business and Economics,
NBER, and CEPR, Campus de Campolide, 1099-032 Lisboa, Portugal. Phone +351-21-3801600. E-mail:
psc@novasbe.pt.
I. Introduction
Although options are well known to help span states of nature [Ross (1976)] and
to provide exposure to (priced) risk factors like stochastic volatility and jumps,1 they are
seldom used in investment portfolios.2 Part of the problem is that the portfolio optimization
methods we have, like the Markowitz mean-variance model, are ill suited to handle options.
There are three main problems in option portfolio optimization. First, the dis-
tribution of option returns departs significantly from normality and therefore cannot be
described by means and variances alone. Second, the short history of options returns avail-
able severely limits the estimation of their complex distribution. For example, we have
data for Standard & Poor’s 500 options only since 1996, which is not long enough to es-
timate the moments of their return distribution with sufficient precision. Third, there are
high transaction costs in this market. On average, at-the-money (ATM) options have a
5% relative bid-ask spread, while out-of-the-money (OTM) options have relative bid-ask
spreads of 10%.
We offer a simple portfolio optimization method that solves these problems simul-
taneously. Instead of a mean-variance objective, we maximize an expected utility function,
such as a power utility, which accounts for all the moments of the portfolio return dis-
tribution and has the advantage of penalizing negative skewness and high kurtosis. We
deal with the limited sample of options returns by relying on data for the underlying asset
instead. Our application uses returns of the S&P 500 index since 1950 to simulate returns
of the underlying asset going forward and, from the definition of option payoffs, generate
simulated option returns.
1
See Bates (1996), Bakshi, Cao, and Chen (1997), Andersen, Benzoni, and Lund (2002), and Liu and
Pan (2003), among others.
2
Mutual funds use of derivatives is limited [Koski and Pontiff (1999), Deli and Varma (2002), Almazan,
Brown, Carlson, and Chapman (2004)]. Mutual funds generally face legal constraints in terms of short-
selling, borrowing and derivatives usage. This does not happen with hedge funds. Most hedge funds use
derivatives, but they represent only a small part of their holdings [Chen (2010), Aragon and Martin (2007)].
1
Plugging the simulated option returns into the utility function and averaging across
simulations gives us an approximation of the expected utility that can be maximized to
obtain optimal portfolio weights. Note that only current options prices are needed in our
procedure, as the payoff is determined by the simulations of the underlying asset.3
We apply our model to portfolio allocation between a risk-free asset and four options
on the S&P 500 index with one month to maturity. We define each option by choosing the
most liquid contract in a predefined range around the specific moneyness. We consider an
ATM call, an ATM put, a 5% OTM call, and a 5% OTM put option. These are liquid
options that can be combined to generate a variety of final payoffs.4
To incorporate transaction costs, we follow Eraker (2007) and Plyakha and Vilkov
(2008). For each option, we define two securities: a “long” option initiated at the ask
quote, and a “short” option initiated at the bid quote. We form a constrained optimization
problem for these eight options, and we identify “short” securities by a negative sign in the
optimization algorithm. By not allowing short-selling, only one of two “options” is ever
bought.
We study the performance of our Optimal Option Portfolio Strategies, which we

denote by OOPS, in an out-of-sample (OOS) exercise. We find the optimal option portfolios
one month before option maturity, and examine the return that they would have had at
maturity. Investors could have obtained the resulting time series of returns following our
method in real time. We can then compute measures of performance such as Sharpe ratios
or alphas to assess the interest of the method. For each OOS observation, only one month
of option observations is needed. For the entire period of 178 monthly observations, 99% of
the sample is OOS. This aspect by itself is significantly different from approaches in other
studies.
3
We consider different alternatives for simulating the returns based on parametric distributions fitted
to the data or simple bootstrap methods. We can also model a time-varying distribution of returns by
simulating their distribution conditional on state variables such as realized volatility.
4
We do not include the S&P 500 in the asset universe because it is spanned by the options.
2
OOPS have high Sharpe ratios and positive certainty equivalents in our sample
period between January 1996 and October 2010. The best strategy yields a Sharpe ratio
of 0.50. This compares well with the Sharpe ratio of the market in the same period of
0.13 (or even in the full sample since 1950 of 0.23). Several strategies also present positive
skewness and low excess kurtosis, which is not achievable simply by shorting individual
options. We find that our strategies load significantly on all four options, and that the
optimal weights vary over time. Finally, our optimal strategies are almost delta-neutral
albeit with significant elasticity.
Hedging demand and long-term considerations can potentially be very important.

Viceira and Campbell (1999) study portfolio choices between equities and the risk-free
rate, and show that hedging demand is a substantial part of overall demand, and there are
high utility losses for failure to hedge intertemporally. Tan (2009) finds that the benefit of
adding options seems to be quite small for long-horizon Constant Relative Risk Aversion
(CRRA) investors who can buy put and call options. Liu and Pan (2003) and Driessen and
Maenhout (2007) show that improvements by including derivatives are driven mostly by a
myopic component. In fact, our results show low predictability of returns of the optimal
strategy. There is also little correlation with the market. These two features imply that
there would be little hedging demand.
A related literature investigates the returns of simple options trading strategies.

Coval and Shumway (2001) show that short positions in crash-protected, delta-neutral,
straddles present Sharpe ratios of around 1.0 and Saretto and Santa-Clara (2009) find
similar values in an extended sample. Driessen and Maenhout (2006) confirm these results
for short-term options in US and UK markets. Coval and Shumway (2001) and Bondarenko
(2003) also find that selling naked puts offers high returns even after taking into account
their considerable risk. These authors, however, do not discuss how to optimally combine
options into a portfolio. Interestingly, we find that our portfolios depart significantly from
exploiting these simple strategies. For instance, there are extended periods in which the
optimal portfolios are net long put options.
3
There are five pieces of research closest that also address the optimal portfolio
allocation with options. Liu and Pan (2003) model stochastic volatility and jump processes
and derive the optimal portfolio policy for a CRRA investor across one stock, a 5% OTM
put option, and cash. Although they obtain an analytic solution for the optimal option
allocation, they need to specify a particular parametric model and estimate its parameters.
They try different parameter sets and obtain ambiguous conclusions in terms of put weights.
Also, they require only one option to complete the market as they consider either a pure
jump risk or a pure volatility risk setting. In our case, we can use any model (parametric
or not) for the distribution of returns of the underlying asset. Our work is empirical in
nature, and we impose no restrictions on the number of options that could be used in the
optimization problem.
Eraker (2007) uses a standard mean-variance framework with a parametric model of

stochastic volatility and jumps to choose among three risky assets: ATM straddles, OTM
puts, and OTM calls. He provides a closed-form solution for weights and obtains an OOS
annualized Sharpe ratio of around 1.6. As in Liu and Pan (2003), estimates are sensitive
to the period considered, despeit the long period required for estimation. Our approach
is more flexible in term of the distribution of returns and the number of options in the
portfolio.
Driessen and Maenhout (2007) analyze the importance of derivatives in portfolio

allocation by using the Generalized Method of Moments (GMM) to maximize the expected
utility of returns for a portfolio of a stock, an option strategy, and cash. They use either
an OTM put, an ATM straddle, or corresponding crash-neutral strategies. They conclude
that positive put holdings that would implement portfolio insurance are never optimal,
given historical option prices.
We find, by contrast, that optimal weights are time-varying, and change signs during
our sample period. Jones (2006) studies optimal portfolios to exploit the apparent put
mispricing. He uses a general nonlinear latent factor model and maximizes a constrained
mean-variance objective. He circumvents the short history of data by using daily options
4
returns. His model is quite complex, with 57 parameters to estimate even when only one
factor is considered. This limits the practical usefulness of his approach.
Constantinides, Jackwerth, and Savov (2009) study portfolios made up of either

calls or puts with a targeted moneyness; they leverage-adjust their returns using options’
elasticity. Although they find high Sharpe ratios, mostly for put strategies, these strategies
yield negative skewness and high kurtosis.
The paper is organized as follows. Section II explains the methodology. Section III
describes the data used. Section IV presents results and findings. Robustness checks are
performed in Section V. Finally, we present some concluding remarks.
II. Portfolio Allocation
A. Methodology
Let time be represented by the subscript t and simulations indexed by n. Our

portfolio allocation is implemented for one risk-free asset and a series of call and put
options with one period to maturity. We assume that there are C call options indexed by c
where c = c1 , ..., cC , and P put options indexed by p where p = p1 , ..., pP . We include only
options that are not redundant by put-call parity. At time t, the value of the underlying
asset is denoted by St , and each option i has an exercise price of Kt,i . The risk-free interest
rate from time t to t + 1, known at time t, is denoted by rft . For each date t, weights are
obtained through maximization of the investor’s expected utility of end-of-period wealth,
which is a linear function of simulated portfolio returns. The latter are derived from option
returns, which in turn depend on the underlying asset returns. The steps below describe
the algorithm used in detail. The Appendix shows a simple illustration.
n
1. We simulate N underlying asset log-returns rt+1 where n = 1, ..., N . Several different
possible simulation schemes can be used. Our simulation is performed under the
empirical density not risk-adjusted measure. We explain the simulation scheme in
detail in the next section.
5
2. The log-returns from step 1 are used to simulate the next period’s underlying asset
value, given its current value:
n n
St+1|t = St exp(rt+1 ) (1)
n
where n = 1, ..., N , and St+1|t denotes the simulated underlying asset value in period
t + 1 conditional on information up to time t.
3. Using known strike prices for call options Kt,c and put options Kt,p and one-period
simulated underlying asset values St+1|t in equation (1), we simulate option payoffs
at their maturity t + 1:
n n n n
Ct+1|t,c = max(St+1|t − Kt,c , 0) and Pt+1|t,p = max(Kt,p − St+1|t , 0) (2)
where n = 1, ..., N . Using these simulated payoffs in equation (2) and current option
prices, returns are then computed by
n n
n
Ct+1|t,c n
Pt+1|t,p
rt+1|t,c = − 1 and rt+1|t,p = −1 (3)
Ct,c Pt,p
where n = 1, ..., N . To compute these returns, we use current option prices Ct,c , c =
c1 , ..., cC and Pt,p , p = p1 , ..., pP at month t. Notice that only one-period-ahead payoffs
are simulated; the denominator of the return is the current observed option price.
4. We construct simulated portfolio returns in the usual way:
cC pP
X X
rpnt+1|t = rft + n
ωt,c (rt+1|t,c − rft ) + n
ωt,p (rt+1|t,p − rft ) (4)
c=c1 p=p1
where n = 1, ..., N . Each simulated portfolio return is a weighted average of the asset
returns, and only the risk-free rate is not simulated.
5. We choose weights by maximizing expected utility over simulated portfolio returns
N
1 X
U Wt [1 + rpnt+1|t ] .

M axω E U Wt [1 + rpt+1|t ] ≈ M axω (5)
N n=1
The output is given by ωt,c , c = 1, ..., C and ωt,p , p = 1, ..., P .
6
6. One-period OOS performance is evaluated with realized option returns.
First, we determine the option realized payoffs:
Ct+1,c = max(St+1 − Kt,c , 0) and Pt+1,p = max(Kt,p − St+1 , 0) (6)
Second, we find the corresponding returns:

Ct+1,c Pt+1,p
rt+1,c = − 1 and rt+1,p = −1 (7)
Ct,c Pt,p
Third, we determine the one-period OOS portfolio return:
cC pP
X X
rpt+1 = rft + ωt,c (rt+1,c − rft ) + ωt,p (rt+1,p − rft ) (8)
c=c1 p=p1
using the weights determined in step 5 above.
B. Return simulation
The first step of the algorithm is to simulate one-period log-returns of the underly-
ing asset. There are many possible approaches to this; see Jackwerth (1999) for a survey
of the literature. Aı̈t-Sahalia and Lo (1998) and Jackwerth and Rubinstein (1996) present
two examples of potential routes one could follow to recover a density function in a con-
tinuous or a discrete time setting, respectively. We follow two approaches, unconditional
and conditional simulation. Either is implemented in two ways, historical bootstrap and
parametric simulation based on historical estimation of the parameters of the density. In
all cases, in each month we use an information set corresponding to an expanding window
of data of the underlying asset up to time t so that the results are out of sample.
First, we explain the unconditional OOPS which takes into account raw returns of
the underlying. Following Efron and Tibshirani (1993), we bootstrap raw returns from
the historical empirical distribution of the underlying distribution up to date t. Hence,
we resample directly from historically observed returns. Implicitly, this corresponds to
drawing returns from their empirical distribution (histogram). We denote this approach as
empirical.
7
Alternatively, we simulate returns using a parametric distribution f estimated from
past data. We use two types of distribution. The first distribution, which is the most
standard in the literature, is a normal distribution with density f (r|µ̂t , σ̂t ) where µ̂t is
the sample mean, and σ̂t is the sample standard deviation. It is known that the normal
distribution does not fit return data well; for one thing, it does not capture the frequency
of extreme events.5 Moreover, the normal distribution does not make sense because it does
not take into account skewness and kurtosis of the stock market. Nonetheless, we still
present results from this experiment.
To extend our analysis to other types of distributions that account for skewness
and kurtosis, we consider a family of distributions that is commonly designated by the
generalized extreme value distribution (GEV). The GEV distribution is defined by the
density f (r|λ̂t , σ̂t , µ̂t ) with shape parameter λ̂t , scale parameter σ̂t , and location parameter
µ̂t .6 It provides a flexible framework that generalizes several distributions. Notice that all
estimated parameters are time-varying, as we use an expanding window up to time t to
estimate them.7
The unconditional approach does not make sense for two reasons. First, an investor
would think options are very expensive when volatility is high. Second, we have not taken
into account that returns may be dependent. Both the bootstrap and the parametric den-
sity approaches assume that returns are independent and identically distributed (i.i.d.),
although it is well known that volatility clusters in time. To capture this issue, we use
standardized log-returns, which we denote by x. We select realized volatility as an esti-
5
Jackwerth and Rubinstein (1996) show that using a normal distribution to model returns, the proba-
bility of a stock market crash like the ones that we have witnessed in the past is 10−160 .
6
The GEV density function is defined in the following way:
r−µ −1−1/λ
( −1/λ
1
λ r−µ

σ 1+λ σ exp − 1 + σ for λ 6= 0
f (r|λ, σ, µ) = r−µ r−µ
1
σ exp(− σ )exp(−exp(− σ )) for λ = 0
The distributions depend crucially on the sign of the parameter λ. A positive sign denotes the Fréchet
class which include well known fat-tailed distributions such as the Pareto, Cauchy, Student-t and mixture
distributions. The zero parameter denotes the Gumbel class and includes the normal, exponential, gamma
and lognormal distributions. A negative sign denotes the Weibull class which includes the uniform and
beta distributions.
7
Parameters are estimated by maximum likelihood using the built-in functions of MATLAB normfit
and gevfit.
8
v
u Dt
uX
2
mate of volatility rvt = t rt,d where Dt is the number of days in month t, and rt,d are
d=1
the daily returns on day d in month t. Standardized log-returns are the ratio of log-return
rt
to the previous month’s realized volatility xt = . This is close in spirit to the filtered
rvt−1
historical simulation of Barone-Adesi, Giannopolos, and Vosper (1999) in which volatil-
ity is estimated by a parametric method such as a generalized autoregressive conditional
heterocedastic (GARCH) model.8
Table I presents summary statistics for raw and standardized returns for the period
between 1950 and 2010 and two subperiods, before and after 1996. By either measure,
returns are lower in the second subperiod. While standardizing returns reduces volatility
in the second period, the opposite happens to raw returns. Both processes show negative
values for skewness between −0.63 and −0.33, but skewness is lower, in absolute terms, for
standardized returns. Raw returns have an excess kurtosis in the first of subperiod around
3 which drops drastically in the second period, and standardization almost eliminates kur-
tosis. The reason is less frequent extreme standardized returns; note, for example, that the
Black Monday extreme negative return is now much smaller. The standardized return is
now only 0.36 standard deviation units away from the mean compared to -6.13 standard
deviation units away from the mean for raw returns.
For the period between 1950 and 1995, the one- and twelve-month autoregressive
coefficients of raw and standardized returns are low and on the order of 0.03, while the
autoregressive coefficient of the squared processes is on the order of 0.10 in absolute value.
Ljung-Box autocorrelation tests for the residuals of raw and standardized returns show no
autocorrelation. According to an ARCH test for the previous one and twelve months, the
i.i.d. hypothesis is rejected for raw returns mainly in the period between 1950 and 1995.
The i.i.d. hypothesis is not rejected for standardized returns at any reasonable significance
level.
8
Properties of standardized returns are presented, for instance, in Andersen, Bollerslev, Diebold, and
Ebens (2001) for stocks and Andersen, Bollerslev, Diebold, and Labys (2003) for exchange rates. They
show that standardized returns are close to i.i.d. normal.
9
The conditional approach uses standardized returns rather than raw returns, with a
slight modification in the first and second steps of the algorithm of the algorithm in Section
A.
1. Simulate standardized returns:

n
rt+1
xnt+1 = (9)
rvt
To obtain xnt+1 we consider the same two ways as in the unconditional simulation,
bootstrapping and parametric simulation.
2. Scale the bootstrapped standardized returns by the current standardized return:

return
n
St+1|t = St exp(xnt+1 × rvt ) (10)
where xnt+1 are the simulated standardized returns from step 1 and rvt is the realized
volatility of the time period between t − 1 and t, which is not simulated.
In either case, unconditional or conditional, current option prices are used in step 3.
This modification takes into account the recurrent change in expectations of the underlying
asset conditional distribution (e.g., OTM put options become more expensive if investors
think there is a greater probability of a crash). Our concept of conditional variable is the
scaling with lagged volatility.
We believe that the conditional strategies work better because option prices are
evaluated according to current volatility. While we do not think that normal distribution
makes sense in this context, we still present those results for comparison reasons.
C. Maximizing expected utility
In the fourth step, the investor maximizes the conditional expected utility of next
period’s wealth:
max E[u(Wt+1 )]
ωi,t ∈R
subject to the usual budget constraint Wt+1 = Wt (1 + rpt+1 ). Maximizing expected utility
takes into account different return distributions. If returns are normal, rational investors
10
care only about the mean and variance of portfolio returns. In practice, this is unlikely to
hold, especially for options returns. Investors care also about tail risk (extreme events), so
mean and variance do not provide enough information to evaluate asset allocation choices.
We use the power utility function [see Brandt (1999)]. This utility function presents
constant relative risk aversion (CRRA) and is given by:

1
W 1−γ ,



1−γ
if γ 6= 1
u(W ) =

ln(W ),
 if γ = 1
where γ is the coefficient of relative risk aversion.9
This utility function is attractive for two reasons. First, because of the homotheticity
property, portfolio weights are independent of the initial level of wealth. So maximizing
E[u(Wt+1 )] is the same as maximizing E[u (1 + rpt )]. Second, investors care about all
moments of the distribution, and this particular utility function penalizes skewness and
high kurtosis. Brandt, Goyal, Santa-Clara, and Stroud (2005) offer approximations of the
optimal portfolio choice.
We set the constant relative risk aversion parameter γ equal to 10 for a conservative
asset allocation choice. To the extent that the investor has lower risk aversion than this
value, this works as a shrinkage mechanism and smoothes the portfolio weights. Rosenberg
and Engle (2002) estimate an empirical risk aversion of 7.36 for S&P 500 index options
data over the sample period between 1991 and 1996. Finally, notice that we could have
used any other utility function in applying our methodology.10
9
For arguments lower than 0.001, we use a first-order approximation of this utility function to avoid
extreme negative values, which is standard in the literature.
10
Driessen and Maenhout (2007) discuss several more sophisticated models and implications for disap-
pointment aversion.
11
D. Transaction costs
There is a large body of literature that documents high transaction costs in the
options market that are in part responsible for some pricing anomalies, such as violations
of the put-call parity relation.11 Hence, it is essential to include these frictions in our
optimization problem. We discuss only the impact of transaction costs measured by the
bid-ask spread. Other types of costs like brokerage fees and market price impacts may be
substantial, but are ignored here.
Figure 1 shows substantial bid-ask spreads for options between 1996 and 2010 op-
tions present. Table II shows average bid-ask spreads of $1.30 for ATM options and $0.70
for OTM options. Dividing this by mid-prices, we measure relative bid-ask spreads for
ATM options of around 5%, increasing to 10% on average for OTM options. Relative
bid-ask spreads change over time and for OTM options can reach up to 30%.12
We incorporate transaction costs by decomposing each option into two “securities”:

a “bid option”, and an “ask option.” We initiate long positions at the ask quote and short
positions at the bid quote, and the latter enters the optimization with a minus sign. This
follows the approach approach taken by Eraker (2007) and Plyakha and Vilkov (2008).
Then we run the algorithm as a constrained optimization problem by imposing a no short-
selling condition. This means that in each month only one of the securities, either the bid
or the ask option, is bought. Note that the wider the bid-ask spread, the less likely an
allocation to the security, as expected returns will be lower.
11
See, for instance, Phillips and Smith (1980), Baesel, Shows, and Thorp (1983), and Saretto and Santa-
Clara (2009).
12
Dennis and Mayhew (2009) shows that the effective spread is about two-thirds of the quoted spread
given in OptionMetrics, so quoted spreads may overestimate costs which seems a conservative assumption
in terms of OOPS performance.
12
III. Data
A. Securities
We analyze the optimal portfolio allocation from January 1996 through October
2010. Choice of the period relates to the availability of options data. We use data that go
back to February 1950 for the simulation process, returns of the Standard & Poor’s 500
index, from February 1950 through October 2010. Figure 2 presents the monthly time-series
of Standard & Poor’s 500 and VIX indices in the overall period.13
There are a variety of market conditions over the period as can be seen from the
cycles in the index and from the evolution of volatility. Events include the 1997 Asian cri-
sis, the 1998 Russian financial crisis, the 1998 collapse of Long Term Capital Management,
the 2001 Nasdaq peak, the September 2001 attack at New York’s World Trade Center, the
2002 business corruption scandals (Enron and Worldcom), Gulf War II, and the 2008 sub-
prime mortgage crisis. The empirical analysis relies on monthly holding-period returns, as
microstructure effects tend to distort higher-frequency returns. For our empirical analysis,
we use S&P 500 index closing prices available from Bloomberg. Based on this, we construct
a time-series of monthly log-returns.
We use data from the OptionMetrics Ivy DB database for European options on the
S&P 500 index traded on the CBOE.14 The underlying asset is the index level multiplied by
100. Options contracts expire on the third Friday of each month. The options are settled
in cash, which amounts to the difference between the settlement value and the strike price
of the option multiplied by 100, on the business day following expiration. The dataset
includes daily highest closing bid and the lowest ask prices, volume, and open interest for
the period between January 1996 and October 2010.
13
VIX is calculated and disseminated by Chicago Board Options Exchange. The objective is to estimate
the implied volatility of short-term ATM options on the S&P 500 index over the next month. The formula
uses a kernel-smoothed estimator that takes as inputs the current market prices for several call and put
options over a range of moneyness and maturities.
14
The options trade under the ticker SPX. Average daily volume in 2008 was 707,688 contracts.
13
In order to eliminate unreliable data, we apply a series of filters. First, we eliminate
all observations for which the bid is lower than $0.125 or higher than the ask price. Second,
we eliminate all observations with no volume to mitigate the impact of non-trading. Finally,
we exclude all observations that violate usual arbitrage bounds.
For the purpose of this study, we assume the risk-free interest rate is represented by
one-month US LIBOR. This series comes from Bloomberg for the period between January
1996 and October 2010.
B. Construction of options returns
Our asset allocation uses a risk-free asset and a set of risky “securities.” We define
four options with different levels of moneyness: an ATM call, an ATM put, a 5% OTM
call, and a 5% OTM put. This limited number of securities keeps the model simple, but
nevertheless generates flexible payoffs as a function of underlying asset price. OTM options
are important for kernel spanning [Burachi and Jackwerth (2001) and Vanden (2004)], and
a deep OTM put option is much more sensitive to negative jump risks. We do not allow
the investor to choose from all available contracts simultaneously, as our investor may then
exploit small in-sample differences between highly correlated option returns, leading to
extreme portfolio weights (see, e.g., Jorion (2000) for a discussion of this issue). These are
also among the most liquid options, using volume as a proxy for liquidity.
We choose one-month maturity options. Burachi and Jackwerth (2001) report that
most of the trading activity in S&P 500 index options is concentrated in the nearest con-
tracts of less than 30 days to expiration. By choosing the one-month maturity we prevent
microstructure problems. This target maturity is also appealing as longer-maturity option
contracts may stop trading of the underlying asset moves in such a way that options become
very deeply ITM or OTM. Yet another advantage is that holding the options to maturity
incurs transaction costs only at inception of the trade.
14
We then construct a time-series of options returns, initially using the midpoint of
bid and ask prices. We first find all available options contracts with exactly one month
to maturity.15 We then define buckets for option moneyness in terms of the ratio of the
underlying price to the strike price less one, S/K − 1. We set a range of moneyness of
between -2.0% and 2.0% for ATM options and a bound 1.5 p.p. away from 5.0% for OTM
options. Basically, we fix target moneyness buckets conditional on one-month maturity
options.
Following this, at each month and for each bucket we are left with several potential
securities, although we want only one option contract in each month. We choose the option
with the lowest relative bid-ask spread, defined as the ratio between the bid-ask spread and
the mid-price. When more than one contract has the same ratio, we choose the one with the
highest open interest.16 Finally, we construct the synthetic one-month hold-to-expiration
option returns:
Payofft+1
rt,t+1 = −1
Pricet
where Payofft+1 is the payoff of the option at maturity calculated using the closing price of
the underlying asset on the day before settlement, and Pricet is the option price observed
at the beginning of the period. We obtain a time-series of 178 observations for each option.
Figure 3 presents kernel density estimates for each option security. We see that
the options return distribution departs significantly from the normal distribution, with
considerable negative tail risk for any of the options considered.
Mean time-series characteristics for each option by option moneyness are presented
in Table II. ATM call and put options have average moneyness of 0.35% and −0.24%,
respectively, while OTM call and put options have average moneyness of −4.05% and
4.41%, respectively. These numbers show how close each contract is to the mean value of
each bucket. Volume for each contract is around 4,000 and open interest is close to 20,000.
15
There are other alternatives that we do not follow. For example, Burachi and Jackwerth (2001), Coval
and Shumway (2001), and Driessen and Maenhout (2006) select options on the first day of each month and
compute returns until first day of the next month.
16
We do not need further criteria, since this already defines a unique contract in each month for each
option type and bucket.
15
Mean implied volatility varies between 15% and 22% with moneyness, which confirms the
known smile effect.
Panel B of Figure 1 shows the implied volatility of each option between 1996 and
2010. Implied volatility is low between 2003 and the mid-2007’s. We can see four pro-
nounced peaks in these time-series in to the year 1998, over 2000-2002 and 2007-2009, and
in mid-2010.
Table III reports summary statistics of returns for the various securities. The pri-
mary performance measure in this study is the Sharpe ratio. The S&P 500 index has an
average monthly return of 0.5% over the sample period, corresponding to an annualized
Sharpe ratio of 0.13.17
We also compute the certainty-equivalent of an investor with risk aversion of 10

and incorporate descriptive statistics of the return distribution, in particular, skewness
and excess kurtosis. S&P 500 index returns present negative skewness and excess kurtosis.
Options present large negative average monthly returns ranging from -0.7% to -39.9%. This
suggests that writing options may be a good strategy, as annualized Sharpe ratios range
from 0.03 to 0.68 for this period.18
Writing options, however, has negative tail risk that may be too onerous in some
months. The returns to writing options have a maximum of 100%, but the minimum ranges
from -463% to -2,496% depending on the option. This leads to large negative skewness and
excess kurtosis between 0.71 and 42.16.
The last row of Table III shows a strategy that allocates the same weight to each
option. DeMiguel, Garlappi, and Uppal (2009) argue that a naive 1/N uniform rule is
generally good. Using this rule for our four risky assets and shorting this strategy, we
17
This is different from the usual stated Sharpe ratios for the US market of on the order of 0.50. The
main reason is the period in question which is not very long. The main problem of a Sharpe ratio is
that it takes into account only the first two moments, the mean and the standard deviation. Broadie,
Chernov, and Johannes (2009) show that although the Sharpe ratio is not the best measure to evaluate
performance in an options framework, other alternative measures as Leland’s alpha or the manipulation
proof performance metric face the same problems. See Bernardo and Ledoit (2000) and Ingersoll, Spiegel,
Goetzmann, and Welch (2007) for problems with the Sharpe ratio.
18
Coval and Shumway (2001) and Eraker (2007) show that writing put options earns Sharpe ratios of
0.68 or above for a different time period.
16
obtain smoother skewness and kurtosis, and an annualized Sharpe ratio of 0.53. This
comes with the same problem as with individual options.
The construction of “bid” and “ask” securities is straightforward. For the chosen
contract, we use the bid quote and the ask quote, respectively. The descriptive statistics
for these contracts are very similar to the ones using mid-prices and are not presented to
save space.
IV. Results
Table IV presents summary statistics of out-of-sample returns for the optimal option
portfolio strategies between January 1996 and October 2010. Note first that all strategies
display annualized Sharpe ratios of between 0.38 and 0.52, higher than the market ratio
of around 0.13. The unconditional OOPS returns have negative skewness (around -1) and
substantial excess kurtosis (around 30). Notice that a -94.3% monthly return may be
possible using this strategy. The best strategy is the one that uses a generalized extreme
value distribution with an annualized Sharpe ratio of 0.52, although the Sharpe ratios are
not very different across simulation methods.19 Certainty-equivalent values are extremely
negative because of the extreme returns.
Conditional OOPS returns, however, present positive skewness (around 1) and

smoother excess kurtosis (around 7). Figure 4 shows that this intrinsically defines a nar-
rower distribution that limits the downside risk. Note by comparison of this figure with the
one for individual options in Figure 3 that these strategies eliminate the substantial left-tail
risk, and they yield almost symmetric distributions with returns truncated by -100% and
100% for unconditional OOPS and by -20% and 20% for conditional OOPS. Annualized
Sharpe ratios are on the order of 0.50, and annualized certainty-equivalents are 4%.
Conditional OOPS returns always have lower standard deviations than uncondi-
tional OOPS returns. These strategies result in negative returns for only 40% of the
19
These strategies are i.i.d., as can be shown using an ARCH test or a Ljung-Box tests (results not
tabulated for space reasons). Hence, there is no need to correct annualized Sharpe ratios for the potential
autocorrelation in strategy returns.
17
months. We perform a GEV fit exercise to analyze the type of distribution for these OOS
OOPS returns (not presented for reasons of space). The implied GEV distribution is much
narrower for the conditional OOPS, with means a little higher than the market, and very
low volatility. The ratio of the mean over standard deviation is on the order of 8.0 compared
to 1.3 for the unconditional strategies.
We then analyze in more detail the OOS returns of the conditional OOPS using
the GEV distribution. The negative extreme returns, which are relatively small, occur in
September 2007 (-8.7%) and September 2001 (-7.2%), corresponding to two events that
were totally unexpected by either the options market or the stock market. On the other
hand, positive extreme returns occur in February 1996 (20.0%), July 1996 (7.8%), May
1997 (13.4%), November 1999 (13.2%), March 2007 (9.8%), and October 2008 (14.1%).
Figure 5 presents the OOPS cumulative returns starting from one dollar invested
in January 1996. This shows the excellent increasing stability of conditional strategies
compared with the good overall performance of the unconditional strategies with their
irregular paths and sudden drops like, for example, the one in September 2008.
Table V reports average weights of each option in each strategy (panel A) and the
proportion of months with positive weights (panel B). This latter measure lets us see if the
security is, on average, “long” or “short,” as the mean may be affected by outlier values.
We complement the analysis using a picture showing the evolution of weights.
Figure 6 represents one example of what happens in terms of weights of the four
risky assets for the parametric simulation using a GEV distribution for conditional OOPS.
All four of the assets have significant weights that offset each other; at some times this
offsetting is not always the same.
For instance, in November 1998 we write -8.6% of an OTM put option and balance
it with an ATM put option weight of 9.4%. In September 1999, call options are more
important. We write an ATM call with a weight of -6.1% and hold a long position of 3.9%
in an OTM call. In August 2008, we write -0.6% of an OTM put option, and we hold a
long position of 2.1% of ATM put options and 1.6% of OTM call options.
18
Another important aspect is the no-investment case. This happens 42% of the
months for ATM call options; see November 2009, for example. Usually we invest in the
other options, except in only 5% of the months. There are also months when we invest
only in one option (e.g., November 2008 corresponds to 1.4% of an OTM call option), two
options (e.g., April 2009 1.4% of an OTM call and 0.1% of an OTM put options), or three
options (e.g., July 1997 1.2% of an ATM call, 0.9% of an ATM put, and -0.7% of an OTM
put option).
These weights are quite different over time. The OOPS are quite different from the
simple short put strategies described in the literature. Note that Driessen and Maenhout
(2007) show that constant relative risk aversion investors always find it optimal to short
OTM puts, and only with distorted probability assessments are they able to obtain positive
weights for puts using cumulative prospect theory and anticipated utility.
Table V also shows that the sign of the position in each option is not really related
to the way we choose to simulate returns. On average, we hold long positions of ATM puts
and OTM calls and short positions of OTM puts. The holdings of ATM call options change
the most.
The second point is that simulating the conditional distribution of returns leads
to an allocation with lower weights in absolute value. The maximum and the minimum
weights of all securities are lower for conditional OOPS, and the mean of the sum of the
absolute values of weights of these eight securities is clearly lower than for unconditional
OOPS. This makes our portfolio less leveraged.
We can check that generally ATM options balance OTM options, which is even more
true when extreme weights are set. Correlation figures confirm these results. The strongest
correlated pairs are the ATM and OTM calls and the ATM and OTM puts (on the order of
-0.70). For the other pairs the correlation is lower than 0.50 in absolute value. Moreover,
put options seem to play a more important role in the allocation than call options. This can
be checked in terms of individual assets and by comparing the sum of absolute weights of
calls and puts. The latter is three times higher for unconditional OOPS and twice as high
19
as for conditional OOPS. Moreover, peaks are most pronounced in put options weights.
One pronounced weight is attributable to September 11, 2011. This seems under-
standable, as this event was in no way expected by the market. The event was absolutely
not priced in the options market, and thus the reason why this affected allocation so much.
Following this event, the period surrounding Long-Term Capital Management bailout is
also very volatile in terms of weights. September 2008 also sees higher weights, but still
not as much as the previous two above.
Our results do not match those of Liu and Pan (2003) who tend to buy OTM put
options. They do not have a choice between different levels of moneyness. For conditional
OOPS we do have a positive net position in put options that agrees with their result.
Our results partially confirm the work of Driessen and Maenhout (2007) because
we short an OTM put option, but we never write straddles. The bottom right picture in
Figure 6 describes the evolution of the risk-free security weight. The mean weight is 98.2%,
and 83% of the months the weight is less than 100%. Hence, no borrowing is the most
standard case. The maximum weight is 107.8% in June 1996, and the minimum is around
91.5% in February 2007.
To measure the sensitivity of this portfolio to potential changes in the underlying

asset we first analyze the Black-Scholes delta. Panel A of Table VI presents summary
statistics of the delta for each of the three strategies for unconditional and conditional
OOPS. The main conclusion is that the portfolio delta is very close to zero, ranging from
-0.25 to 0.08 with a mean of around 0. Most months, the portfolio delta is negative.
Conditional OOPS have a narrower range of deltas implying less risk.
A better measure of risk is the elasticity of the portfolio. The elasticity of an option
is described by multiplying the delta by the ratio between the underlying asset value and
the option value. This measure has the advantage that it takes into account option leverage.
Panel B of Table VI presents summary statistics for elasticity. The mean value is
around -9, hence an increase of 1 percentage point in the underlying asset, is expected to
20
impact the portfolio by -9 percentage points, on average. This means that we typically hold
a large net short position, although our strategies are clearly targeted to prevent extreme
bad outcomes. A negative return for the OOPS strategies against a positive return for the
market happens only in 28% of the months and with an implied monthly average return of
only -1.53%. Note that in only 49% of the months is elasticity higher than 8 in absolute
value. In fact OOPS are much less elastic than individual options.20 Conditional OOPS
have much less extreme negative elasticity than unconditional OOPS.
Figure 7 shows the evolution of elasticity in the period between January 1996 and
October 2010 for a simulation using a GEV distribution of conditional OOPS. This series
is quite volatile. There are three main periods below -20, such as around 1998–1999, 2007–
2008, and 2010. August and September 2008 this series attains its lowest value of around
-44.
We next investigate which variables explain or predict our results, in particular, the
out-of-sample OOPS returns. The variables include rS&P 500 , the S&P 500 index monthly
return as a proxy for the market; and jump, the variable related to jump risk proxied by a
binary variable equal to the absolute value of the S&P 500 index return when the current
monthly return is below -5% and zero otherwise. Volatility is measured in two different
ways: realized volatility (svol) of the last month using daily data, and the V IX level (vix).
We also construct a variable that is the spread between the implied and realized volatility
(vixsvol) a standard approach in the literature. Skew represents the probability of left-
tail risk, meaning that a higher value is associated with more left-tail risk than a normal
distribution.21
We also use first-differences in the monthly values for some of these variables, and
we denoted by the symbol ∆. All these variables are customary in the equities and options
literature.
20
Elasticity for individual options is presented in Table II.
21
This time-series is taken from the CBOE website, but we divide by 100 to make the analysis easier.
21
Table VII reports the results for both unconditional and conditional OOPS.22 Many
variables show modest explanatory power as demonstrated by a relatively high R2 corre-
sponding to a maximum of 17%, particularly, market returns, jumps, and volatility for
unconditional OOPS. Only skew is irrelevant. Most of the variables have no predictive
power. There is some statistical significance of volatility variables for some simulations;
the maximum R2 is 7%.
Unconditional OOPS returns are profitable, on average, when the market increases,
when a negative jump occurs, and when mean risk declines.23 Conditional OOPS returns
are more difficult to explain. No variable is able to explain all three strategies, but the strat-
egy does well when risk increases. Notice the opposite signs on the conditional compared
to the unconditional OOPS for all variables even if they are not significant. Explanatory
regressions have a maximum R2 of 3%. There is almost no predictive power in terms of
conditional OOPS, which translates to a maximum R2 of 2%. We conclude that there is
no variable that explains conditional OOPS returns.
To summarize the results, conditional OOPS present good stable performance with
reduced weights on options and relatively less risk than the unconditional OOPS.
V. Robustness Checks
We perform some robustness tests only for conditional OOPS, as we have shown
these strategies behave the best. The first test examines the impact of choosing fewer
assets in each OOPS. A variety of authors use a restricted set of options to develop optimal
strategies.24
22
We tried different explanatory variables and models. There is insignificant exposure to the Carhart
factors or Fung and Hsieh hedge fund factors.
23
Jones (2006) confirms that three factors explain the cross-section of option returns: market, volatility,
and jump.
24
Liu and Pan (2003) use one stock, a 5% OTM put option, and cash. Eraker (2007) chooses among three
risky assets, ATM straddles, OTM puts, and OTM calls. Jones (2006) uses only put options. Driessen and
Maenhout (2007) analyze the choices among stock, an option strategy, and cash. They use either an OTM
put, an ATM straddle or corresponding crash-neutral strategies. Constantinides, Jackwerth, and Savov
(2009) use either call or put options.
22
Table VIII presents the most relevant statistics for understanding their performance.
Each row describes a different portfolio choice, where each number represents a different
option choice considered. The digits 1, 2, 3, and 4 denote the ATM call, the ATM put,
the 5% OTM call, and the 5% OTM put options, respectively. When more than one digit
appears, that strategy involves a combination of options.
The strategy with four option securities yields simultaneously the best Sharpe ratio
(around 0.50) and certainty-equivalent values (around 5%) with low kurtosis and positive
skewness for the different simulation methods. For portfolios formed by only one option,
there is no strategy that yields a positive Sharpe ratio, although using an ATM call delivers
a positive annualized certainty-equivalent. A strategy with only a 5% OTM put option
yields both the poorest Sharpe ratio and certainty equivalent value.
Portfolios formed with two options all present positive Sharpe ratios, mainly around
0.40. The strategy that combines an ATM call option with a 5% OTM put option achieves
a Sharpe ratio of 0.53 for the empirical simulation, but then falls to 0.30 in GEV simulation.
The same happens to the certainty-equivalent (from around 4% to close to 0%). Two other
strategies seem to work as well: investing in both call options or in both put options.
Strategies with three options present moderate or negative Sharpe ratios and certainty
equivalents.
We conclude that smaller security sets do not work well because they do not allow
the investor to control risk by, for example, buying one put and shorting another put. The
ones that work better are related to the choice of an even number of securities since there
is the need to counterbalance short and long positions in options.
Second, we analyze the effect of risk aversion on portfolio choice. Table IX presents
the most relevant statistics for understanding performance of the strategies. Each row
presents a different risk aversion parameter, γ.
We follow two approaches. The first is to understand the effect of changing the risk
aversion parameter, γ, from 10 to 5, 3, or 2. In Panel A of Table IX, note as γ declines, the
skewness becomes even more positive, but kurtosis also increases. This negatively impacts
23
overall performance as the Sharpe ratio is lower. The certainty-equivalent is negative only
when γ is 2. Very low γ also does not work well because it does not weight the tail risk
of the strategies strongly enough. Nonetheless, the overall results show the outstanding
behavior of OOPS.
The second approach involves the use of a mean-variance utility function U = µp −

γ 2
σ .
2 p
Panel B of Table IX shows the results. Although the strategies have positive skewness,
they also have substantial excess kurtosis and yield low annualized Sharpe ratios. The
problem now is that their mean delta is around 0.20 and mean elasticity is around 230.
This is a high-leverage strategy with mean weights of 80% on an OTM call option and -15%
on an OTM put option. This yields a strategy for 63% of the months where all money lost is
compensated by opportunistic high returns, a strategy that could hardly be implemented.
This shows the importance of using an objective function that penalizes negative skewness
and high kurtosis. A mean-variance utility function does not work well in this setup.
In a third robustness check, we examine the performance of a representative investors

who holds the market. The algorithm in Section II is changed in Step 4. We construct
simulated portfolio returns
cC pP
X X
rpnt+1|t = n
rt+1|t,m + n
ωt,c (rt+1|t,c − rft ) + n
ωt,p (rt+1|t,p − rft ) (11)
c=c1 p=p1
n
where n = 1, ..., N , and rt+1|t,m is the simulated market return from Step 1 of algorithm in
Section II.
Table X shows that these strategies do not perform as well as before. Certainty-
equivalents are highly deep negative and have huge excess kurtosis, besides positive Sharpe
ratios. This implies a delta magnitude of very close to one. These strategies put more
pronounced weights on each option.
24
VI. Conclusion
We offer a new method for portfolio optimization using options. The approach
relies on simulating option payoffs from a given distribution of the underlying asset and
using those returns to maximize an expected utility function. This takes into account the
complex distribution of option returns and investor preferences for higher-order moments.
One advantage of our approach is that it does not rely on a long time series of option
returns, but rather just current observed prices. The approach also takes into account
transaction costs in a simple manner.
We apply the method out-of-sample in the period 1996 to 2010 with impressive re-
sults. The method is straightforward to implement (even on a spreadsheet) and requires
virtually no computing resources. We obtain high Sharpe ratios and other good perfor-
mance measures that take into account the non-normality of the return distribution.
25
Appendix A
We fix two time periods, t = 1 and t = 2. In the former, we run the optimization problem and
obtain the weights of each security for our asset allocation. In the latter, we perform our out-
of-sample exercise. We set the underlying asset value at period 1 equal to 1.00 (S1 = 1) and at
period 2 equal to 0.98 (S2 = 0.98), only known at period 2, and the one-period risk-free interest
rate equal to 10% (rf = 0.1), the same for both periods. We assume two call options (ATM, c1 ,
and OTM, c2 ) and two put options (ATM, p1 , and OTM, p2 ). Their strike prices are given by
K1,c1 = K1,p1 = 1, K1,c2 = 1.05 and K1,p2 = 0.95. The prices of the options at date t = 1 are
given by C1,c1 = 0.04, C1,c2 = 0.0008, P1,p1 = 0.07, and P1,p2 = 0.02. We assume a power utility
with γ = 10.
1. Simulate the underlying asset log-return
r21 = 0.0500 r22 = 0.0100 r23 = −0.0400 r24 = −0.1000
2. Find the next-period underlying asset value

1 = 1.0513
S2|1 2 = 1.0101
S2|1 3 = 0.9608
S2|1 4 = 0.9048
S2|1
3.a. Determine simulated option payoffs at maturity

1
C2|1,c = 0.0513 2
C2|1,c = 0.0101 3
C2|1,c = 0.0000 4
C2|1,c = 0.0000
1 1 1 1
1
C2|1,c2 = 0.0013 2
C2|1,c2 = 0.0000 3
C2|1,c2 = 0.0000 4
C2|1,c = 0.0000
2
1
P2|1,p1 = 0.0000 2
P2|1,p1 = 0.0000 3
P2|1,p = 0.0392 4
P2|1,p = 0.0952
1 1
1
P2|1,p2 = 0.0000 2
P2|1,p2 = 0.0000 3
P2|1,p = 0.0000 4
P2|1,p = 0.0452
2 2
3.b. And corresponding returns for each option
1
r2|1,c = 0.2818 2
r2|1,c = −0.7487 3
r2|1,c = −1.0000 4
r2|1,c = −1.0000
1 1 1 1
1
r2|1,c2 = 0.5589 2
r2|1,c2 = −1.0000 3
r2|1,c2 = −1.0000 4
r2|1,c = −1.0000
2
1
r2|1,p = −1.0000 r 2 = −1.0000 3
r2|1,p = −0.4398 4
r2|1,p = 0.3595
1 2|1,p1 1 1
1
r2|1,p2 = −1.0000 2
r2|1,p2 = −1.0000 3
r2|1,p2 = −1.0000 4
r2|1,p = 1.2581
2
4. Construct the simulated portfolio return

rp12|1 = 0.10+ rp22|1 = 0.10+ rp32|1 = 0.10+ rp42|1 = 0.10
+ω2,c1 × 0.2818+ +ω2,c1 × (−0.7487)+ +ω2,c1 × (−1.0000)+ +ω2,c1 × (−1.0000)
+ω2,c2 × 0.5589+ +ω2,c2 × (−1.0000)+ +ω2,c2 × (−1.0000)+ +ω2,c2 × (−1.0000)
+ω2,p1 × (−1.0000)+ +ω2,p1 × (−1.0000)+ +ω2,p1 × (−0.4398)+ +ω2,p1 × (0.3595)+
+ω2,p2 × (−1.0000) +ω2,p2 × (−1.0000) +ω2,p2 × (−1.0000) +ω2,p2 × 1.2581
(1+rpn )−9
5. Choose weights by maximizing expected utility over simulated returns 14 4n=1 2|1
P
−9
ω2,c1 = 0.02, ω2,c2 = −0.03, ω2,p1 = −0.01, ω2,p2 = −0.12 and E(U ) = −0.0369
6.a. Determine option actual payoffs... 6.b. ...and returns for each option
C2,c1 = 0.0000 r2,c1 = −1.0000
C2,c2 = 0.0000 r2,c2 = −1.0000
P2,p1 = 0.0200 r2,p1 = −0.7143
P2,p2 = 0.0000 r2,p2 = −1.0000
6.c. Determine one-period OOS portfolio return
rp2 = 0.2511
26
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29
Figure 1
Bid-ask spread and implied volatility
This figure represents monthly observations of relative bid-ask spread (the ratio of absolute
bid-ask spread and mid price) and implied volatility (using Black-Scholes model) measures
for the period between January 1996 and October 2010 for four options: an ATM call, an
ATM put, a 5% OTM call, and a 5% OTM put options. Each option security was cre-
ated as defined in Section II. Results in percentage. Period: January 1996 to October 2010.
Relative Bid-ask Spread

40
ATM call ATM put OTM call OTM put
30
%
20
10
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Year
Implied Volatility
80
ATM call ATM put OTM call OTM put
60
%
40
20
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Year
30
Figure 2
S&P 500 Index and VIX
This figure represents monthly observations of S&P 500 Index and VIX Index. Period:
January 1996 to October 2010.
1600 60
VIX
S&P 500 Index
1400 50
1200 40
S&P 500 Index
VIX (%)
1000 30
800 20
600 10
1996 1998 2000 2002 2004 2006 2008 2010
Year
31
Figure 3
Densities of monthly option returns
This figure represents the densities of monthly raw returns of a long position in ATM and
5% OTM options over the S&P 500 index estimated by normal kernel smoothing. Period:
January 1996 to October 2010.
ATM call ATM put
-200 0 200 400 600 800 -200 0 200 400 600 800
Returns (%) Returns (%)
OTM call OTM put
-200 0 200 400 600 800 -200 0 200 400 600 800
Returns (%) Returns (%)
32
Figure 4
OOPS return distribution
This figure presents the distribution of OOS one-month OOPS returns for three strategies
(empirical, normal and GEV) as explained in Section II using unconditional and condi-
tional OOPS. Period: January 1996 to October 2010.
Unconditional OOPS - Empirical Unconditional OOPS - Normal Unconditional OOPS - GEV
-100 0 100 -100 0 100 -100 0 100

Returns (%) Returns (%) Returns (%)
Conditional OOPS - Empirical Conditional OOPS - Normal Conditional OOPS - GEV
-100 0 100 -100 0 100 -100 0 100

Returns (%) Returns (%) Returns (%)
33
Figure 5
OOPS cumulative returns
This figure presents OOS one-month OOPS cumulative returns for three strategies (em-
pirical, normal and GEV) as explained in Section II using unconditional and conditional
OOPS. Period: January 1996 to October 2010.
Unconditional OOPS Cumulative Returns

15
Empirical Normal GEV
10
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Year
Conditional OOPS Cumulative Returns

5
4
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Year
34
Figure 6
OOPS time-series weights
This figure represents the monthly weights of conditional OOPS constructed by simulation
from a GEV distribution. Top left panel presents weights for ATM call and 5% OTM call
options. Top right panel presents weights for ATM put and 5% OTM put options. Bottom
left panel presents weigths for the difference between ATM options and OTM options.
Bottom right panel presents the weight of the risk-free security. Period: January 1996 to
October 2010.
10 10
ATM call ATM put
OTM call OTM put
5 5
Weight (%)
Weight (%)
0 0
-5 -5
-10 -10
199619971998199920002001200220032004200520062007200820092010 199619971998199920002001200220032004200520062007200820092010
Year Year
10 110
ATM call - ATM put Risk-Free
OTM call - OTM put
5 105
Weight (%)
Weight (%)
0 100
-5 95
-10 90
199619971998199920002001200220032004200520062007200820092010 199619971998199920002001200220032004200520062007200820092010
Year Year
35
Figure 7
OOPS elasticity
This figure presents conditional OOPS portfolio monthly elasticity from a simulation using
a GEV distribution. Period: January 1996 to October 2010.
10
-10
Elasticity
-20
-30
-40
-50
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Year
36
Table I
S&P 500 Index Returns – Summary Statistics
This table reports summary statistics (number of observations, mean, standard deviation, mini-
mum, 5% percentile, first quartile, median, third quartile, 95% percentile, maximum, skewness,
excess kurtosis, one and twelve month autocorrelation for the residuals and square residuals) and
tests (one and twelve month LjungBox and Arch tests; p-values of each test are presented in
squared brackets) for raw returns and standardized returns for S&P 500 index. Standardized re-
turns are raw returns divided by realized volatility of previous month. The results are presented
for three periods: February 1950-December 1995, January 1996-October 2010, and February 1950-
October 2010.
Raw returns Standardized returns

1950-1995 1996-2010 1950-2010 1950-1995 1996-2010 1950-2010
Obs 551 178 704 551 178 729
Mean 0.7% 0.4% 0.6% 22% 19% 21%
Std Dev 4.0% 4.8% 4.2% 129% 99% 122%
Min -24.5% -16.9% -24.6% -487% -334% -487%
q5% -6.2% -8.5% -6.4% -206% -137% -190%
q25% -1.7% -2.1% -1.8% -59% -47% -54%
q50% 0.9% 1.0% 0.9% 28% 26% 27%
q75% 3.4% 3.6% 3.5% 101% 88% 98%
q95% 6.7% 7.4% 6.9% 215% 167% 207%
Max 15.1% 9.4% 15.1% 354% 288% 354%
Skew -0.56 -0.74 -0.63 -0.33 -0.33 -0.33
Exc Kurt 2.97 0.85 2.30 0.54 0.33 0.65
ρ1 (z) 0.03 0.11 0.05 0.03 -0.02 0.02
ρ12 (z) 0.03 0.10 0.06 -0.01 0.03 0.00
ρ1 (z 2 ) 0.10 0.20 0.13 -0.11 -0.08 -0.09
ρ12 (z 2 ) 0.02 -0.01 0.01 0.02 0.02 0.04
Q1 (z) 0.44 2.01 0.44 0.47 0.05 0.47
[0.51] [0.16] [0.51] [0.49] [0.83] [0.49]
Q12 (z) 11.78 11.13 11.78 9.81 7.87 9.81
[0.46] [0.52] [0.46] [0.63] [0.80] [0.63]
Arch(1) 9.60 7.76 9.60 3.96 1.37 3.96
[0.00] [0.01] [0.00] [0.05] [0.24] [0.05]
Arch(12) 22.07 16.71 22.07 12.09 6.32 12.09
[0.04] [0.16] [0.04] [0.44] [0.90] [0.44]
37
Table II
Summary statistics of options
This table reports averages of option moneyness, bid-ask spread, relative bid-ask spread, volume,
open interest, implied volatility, delta and elasticity for four options: ATM call, ATM put, 5%
OTM call, and 5% OTM put options using mid prices. Option moneyness is defined as S/K-1.
Bid-ask spread is the difference between ask price and bid price. Relative bid-ask spread is the
ratio of the bid-ask spread by the mid price. Volume is the contract’s volume at the day when
there is one month to expiration. Open interest is the open interest prevalent at the day with
one month to expiration. Implied volatility is the annualized volatility of the option with one-
month to maturity using the Black-Scholes model. Delta is the Black-Scholes delta. Elasticity
is the product of delta by the ratio of underlying asset value and option price. Period: January
1996-October 2010.
ATM Call ATM Put OTM Call OTM Put

Option moneyness 0.35% -0.24% -4.05% 4.41%
Bid-ask spread 1.36 1.28 0.67 0.81
Relative bid-ask spread 4.67% 4.75% 10.09% 7.42%
Volume 6,708 10,108 9,065 10,882
Open interest 5,065,962 5,029,241 5,039,099 5,048,598
Implied volatility 18.82% 19.91% 16.82% 22.88%
Delta 0.56 -0.48 0.20 -0.22
Elasticity 25.80 -24.62 46.84 -29.46
38
Table III
Summary statistics of returns
This table reports summary statistics (mean, standard deviation, minimum, maximum, skewness,
excess kurtosis, annualized Sharpe ratio) for a buy-and-hold strategy in several return assets:
S&P 500 index, 1-month US Libor, a ATM call option, a ATM put option, a 5% OTM call option
and a 5% OTM put option. Option returns are based on contracts with one-month to maturity
and each month a contract is selected such that it has the minimum bid-ask spread and, when
draws are available, the largest open interest. Statistics are presented for monthly returns and
computed over one-month period prior to the maturity date. The last row presents a strategy
that allocates a weight of 1/4 to each one of the options previously selected. The period under
consideration is between January 1996 and October 2010.
Exc Ann Ann

Mean Std Dev Min Max Skew
Kurt SR CE
S&P 500 0.5% 4.7% -16.9% 9.7% -0.65 0.70 0.13 -9.2%
1m US Libor 0.3% 0.2% 0.1% 0.6% -0.30 -1.45 - -
ATM call -0.7% 119.9% -100% 463% 1.16 0.71 -0.03 -100%
ATM put -16.7% 145.3% -100% 649% 2.41 6.28 -0.40 -100%
OTM call -9.0% 269.9% -100% 2,496% 5.54 42.16 -0.12 -100%
OTM put -39.9% 204.1% -100% 1,116% 4.11 17.18 -0.68 -100%
1/N Rule -16.6% 109.9% -100% 664% 2.75 9.80 -0.53 -100%
39
Table IV
Out of sample OOPS returns
This table reports time-series summary statistics (mean, standard deviation, minimum, maxi-
mum, skewness, excess kurtosis, annualized Sharpe ratio, annualized Certainty Equivalent, GEV
distribution estimated parameters) for the market represented by the S&P 500 index and the
OOS one-month OOPS returns for three strategies (empirical, normal and GEV) as explained in
Section II using unconditional and conditional OOPS in the period from January 1996 to October
2010. Statistics are presented for monthly returns and computed over one-month period prior to
the maturity date.
Unconditional OOPS Conditional OOPS

S&P 500
Empirical Normal GEV Empirical Normal GEV
Mean 0.5% 1.3% 1.8% 2.4% 0.7% 0.7% 0.8%
Std Dev 4.7% 9.0% 10.9% 13.7% 2.8% 3.6% 3.6%
Min -16.9% -39.0% -81.5% -94.3% -7.4% -19.2% -8.5%
q5% -8.2% -5.5% -12.8% -10.3% -2.9% -3.8% -3.7%
q95% 7.6% 9.4% 13.1% 14.9% 4.5% 6.4% 6.5%
Max 9.7% 87.9% 47.2% 95.7% 14.9% 14.5% 20.0%
Skew -0.7 4.4 -2.9 -0.4 2.2 -0.1 1.6
Exc Kurt 0.7 51.0 22.5 26.6 8.5 6.9 5.8
Ann SR 0.13 0.38 0.48 0.52 0.49 0.41 0.50
Ann CE -9.2% -48.1% -100.0% -100.0% 4.5% -0.3% 3.4%
40
Table V
OOPS weights
Panel A of this table presents mean time-series weights for three strategies (empirical, normal and
GEV) as explained in Section II using unconditional and conditional OOPS. Min (Max) stands
for the minimum (maximum) weight position in any of the months and any of the risky securities.
Sum Abs (Sum Abs Calls, Sum Abs Puts) denotes the mean sum of absolute weights of the four
options (call options, put options). Panel B presents the proportion of positive weights over time.
Period: January 1996 to October 2010.
Panel A: Time-series weights mean

ATM Call -1.6% -2.0% -1.4% -0.3% -0.5% -0.2%
Long 0.2% 0.2% 0.3% 0.1% 0.2% 0.3%
Short 1.8% 2.2% 1.7% 0.5% 0.7% 0.5%
ATM Put -1.6% 1.9% 4.4% 0.8% 2.4% 2.7%
Long 0.3% 2.7% 5.1% 0.8% 2.4% 2.7%
Short 1.9% 0.8% 0.7% 0.0% 0.0% 0.0%
OTM Call -0.5% 0.9% 0.8% 0.9% 1.2% 1.2%
Long 0.2% 0.4% 0.5% 0.9% 1.2% 1.2%
Short 0.8% 1.3% 1.3% 0.0% 0.0% 0.0%
OTM Put -0.6% -6.3% -8.3% -0.8% -1.9% -1.9%
Long 0.3% 0.2% 0.1% 0.0% 0.1% 0.1%
Short 0.9% 6.5% 8.3% 0.8% 2.0% 2.0%
Min -44.1% -99.0% -211.1% -6.1% -8.0% -8.6%
Max 34.4% 53.5% 179.4% 5.8% 13.8% 9.4%
Sum Abs 6.3% 14.1% 17.8% 3.2% 6.5% 6.6%
Sum Abs Calls 3.0% 4.0% 3.6% 1.6% 2.0% 2.0%
Sum Abs Puts 3.3% 10.2% 14.1% 1.7% 4.5% 4.7%
Panel B: Proportion of positive weights
ATM Call 19.1% 16.9% 22.5% 16.9% 19.7% 25.8%
ATM Put 26.4% 77.5% 96.1% 68.5% 93.3% 96.1%
ATM Call 39.3% 55.1% 62.9% 92.1% 94.4% 94.9%
OTM Put 3.9% 1.7% 0.6% 3.4% 0.6% 2.2%
41
Table VI
OOPS risk measures
This table presents summary statistics regarding delta and elasticity (time-series mean, standard
deviation, minimum, 5% percentile, median, 95% percentile, maximum) of three strategies (em-
pirical, normal and GEV) as explained in Section II using unconditional and conditional OOPS
in the period from January 1996 to October 2010. Panel A presents results for delta and Panel
B presents results for elasticity.
Panel A: Delta
Mean 0.00 -0.01 -0.01 0.00 -0.01 -0.01
Std 0.01 0.01 0.02 0.01 0.01 0.01
Min -0.04 -0.09 -0.25 -0.03 -0.03 -0.03
q0.05 -0.01 -0.02 -0.02 -0.01 -0.02 -0.02
q0.50 0.00 -0.01 -0.01 0.00 -0.01 -0.01
q0.95 0.01 0.01 0.00 0.01 0.00 0.00
Max 0.02 0.08 0.03 0.01 0.04 0.01
Panel B: Elasticity
Mean -1.82 -8.81 -12.77 -2.56 -9.20 -9.05
Std 9.25 13.22 23.90 6.93 9.66 8.32
Min -67.66 -108.97 -297.45 -36.89 -45.92 -43.49
q0.05 -17.70 -25.69 -31.87 -17.06 -25.70 -25.52
q0.50 -0.05 -7.31 -9.81 -1.49 -8.24 -7.81
q0.95 7.74 4.31 1.78 5.37 1.56 1.74
Max 22.52 71.61 19.29 12.70 53.20 8.34
42
Table VII
Explanatory and predictive regressions for OOPS returns
This table presents estimated betas and maximum R2 across all regression for explanatory and
predictive regressions in which the dependent variable is the OOPS returns out-of-sample and the
independent variable is the variable stated in the first column as explained in Section IV. The
results are presented for three strategies (empirical, normal and GEV) as explained in Section
II using unconditional and conditional OOPS in the period from January 1996 to October 2010.
Panel A presents results for explanatory regressions and Panel B presents results for predictive
regressions. ***, **, * denotes significative estimated parameters at 1%, 5%, and 10% levels,
respectively.
Panel A: Betas of explanatory regressions rtOOS − rft = α + βXt + t

Xt Empirical Normal GEV Empirical Normal GEV
∗∗∗ ∗∗∗
rS&P 500 0.09 0.30 0.27 −0.01 −0.01 −0.04∗∗
jump −0.20∗∗ −0.54∗∗∗ −0.54∗∗∗ 0.02 0.01 0.05
∗∗ ∗∗ ∗∗∗
∆ svol −0.35 −0.88 −1.15 0.07 0.08 0.13∗∗
∆ vix −0.03 −0.17∗ −0.06∗∗∗ 0.01 0.01 0.02
∆ skew −1.76 −8.25 −18.81 2.78 2.19 1.38
Max R2 0.03 0.17 0.12 0.02 0.02 0.03
OOS
Panel B: Betas of predictive regressions rt − rft = α + βXt−1 + t
Xt−1 Empirical Normal GEV Empirical Normal GEV
∗ ∗∗∗
svol 0.08 0.32 0.56 -0.03 -0.02 -0.04
∗∗∗ ∗∗∗
vix 0.08 0.30 0.41 -0.02 -0.02 -0.04
∗∗∗ ∗∗∗
vixsvol 0.11 0.41 0.49 -0.02 -0.02 -0.05
jump -0.03 -0.05 -0.11 0.01 0.01 -0.01
skew -0.55 -4.78 5.26 0.02 -0.28 0.09
∆ svol 0.02 0.05 -0.20 0.01 0.09 -0.03
∗∗
∆ vix 0.08 0.16 0.27 -0.01 -0.01 -0.03
Max R2 0.01 0.06 0.07 0.01 0.02 0.02
43
Table VIII
Different security sets
This table presents OOS skewness, excess kurtosis, annualized Sharpe Ratio and annualized Cer-
tainty Equivalent for three strategies (empirical, normal and GEV) as explained in Section II
using conditional OOPS in the period from January 1996 to October 2010. Each row represents
a different option choice. 1 denotes ATM call option, 2 denotes ATM put option, 3 denotes 5%
OTM call option, 4 denotes 5% OTM put option, and the remaining strategies are just simulta-
neous choice of more than one option according to this codification, e.g., 13 denotes ATM call
and 5% OTM call options.
Conditional OOPS
Asset Exc Ann Ann Exc Ann Ann Exc Ann Ann
Skew Skew Skew
choice Kurt SR CE Kurt SR CE Kurt SR CE
1 1.63 4.49 -0.15 0.98% 1.66 4.61 -0.15 1.16% 1.63 4.14 -0.15 0.69%
2 3.18 13.13 -0.04 0.43% 3.19 13.21 -0.08 0.39% 2.96 11.00 -0.13 -0.55%
3 6.66 57.81 -0.01 -2.14% 6.83 60.73 -0.01 -1.81% 6.78 59.98 -0.04 -3.10%
4 4.25 20.50 -0.22 -3.47% 4.19 19.81 -0.25 -3.25% 4.13 18.99 -0.34 -5.10%
12 1.22 3.79 0.45 4.34% 1.38 4.60 0.47 4.41% 1.46 4.55 0.31 2.42%
13 4.22 30.47 0.05 -5.62% 4.80 37.21 0.05 -8.06% 5.31 42.31 0.01 -10.88%
14 1.57 5.78 0.53 4.51% 1.92 7.53 0.53 4.10% 1.94 6.93 0.30 0.21%
23 3.36 18.55 0.34 1.14% 3.98 27.38 0.31 -0.19% 4.77 36.07 0.18 -3.41%
24 4.05 20.53 0.47 1.68% 3.94 19.33 0.45 0.13% 3.85 18.02 0.30 -5.16%
34 5.70 48.76 0.41 0.74% 5.34 43.73 0.40 -0.29% 5.19 41.60 0.24 -5.58%
123 2.21 9.31 0.25 2.49% -0.47 13.16 0.07 -4.43% 0.01 12.64 0.01 -5.80%
124 3.87 23.22 0.14 -1.70% 2.07 12.43 -0.05 -12.65% 2.89 13.83 -0.01 -9.58%
134 1.84 8.02 -0.03 -4.70% 0.38 7.19 -0.17 -23.15% 3.02 17.51 -0.14 -11.18%
234 2.91 13.13 0.39 2.76% 1.09 15.18 0.31 -13.33% 3.98 24.09 0.29 -0.02%
1234 2.15 8.52 0.49 4.50% -0.12 6.91 0.41 -0.32% 1.63 5.81 0.50 3.41%
44
Table IX
Different preferences
This table presents OOS skewness, kurtosis, annualized Sharpe Ratio and annualized Certainty
Equivalent for three strategies (empirical, normal and GEV) as explained in Section II for con-
ditional OOPS in the period from January 1996 to October 2010. Panel A uses a CRRA utility
function whereas Panel B uses a mean variance utility. Each row represents a different risk aver-
sion parameter.
Panel A: Conditional OOPS - CRRA utility

Exc Ann Ann Exc Ann Ann Exc Ann Ann
γ Skew Skew Skew
Kurt SR CE Kurt SR CE Kurt SR CE
2 2.93 14.52 0.30 -3.08% 1.99 8.76 0.34 -8.14% 2.35 10.18 0.28 -13.07%
3 2.49 11.41 0.36 1.86% 1.51 6.18 0.43 0.02% 1.88 7.09 0.36 -3.71%
5 2.17 9.30 0.42 3.95% 1.19 4.58 0.52 3.74% 1.57 5.17 0.43 1.36%
10 2.15 8.52 0.49 4.50% -0.12 6.91 0.41 -0.32% 1.63 5.81 0.50 3.41%
Panel B: Conditional OOPS - Mean Variance utility
Exc Ann Ann Exc Ann Ann Exc Ann Ann
γ Skew Skew Skew
Kurt SR CE Kurt SR CE Kurt SR CE
2 5.15 38.78 0.20 - 5.14 38.68 0.17 - 5.20 38.97 0.08 -
3 5.18 39.26 0.20 - 5.19 39.20 0.16 - 5.24 39.47 0.07 -
5 5.23 39.86 0.23 - 5.23 39.70 0.15 - 5.27 39.92 0.06 -
10 6.51 58.03 0.25 - 5.48 42.97 0.15 - 5.34 40.76 0.10 -
45
Table X
Different investor background risk
This table presents OOS returns, weights, and risk measures descriptive statistics for three strate-
gies (empirical, normal, and GEV) as explained in Section V for unconditional and conditional
OOPS in the period from January 1996 to October 2010.
Panel A: Time-series OOS return

Mean 1.1% 2.1% 1.3% 0.8% 0.5% 0.9%
Std Dev 10.0% 10.4% 12.2% 9.3% 6.8% 9.8%
Min -43.1% -60.6% -75.5% -23.3% -24.0% -24.1%
q5% -8.2% -8.5% -9.6% -10.9% -12.1% -11.3%
q95% 11.4% 16.9% 15.7% 10.0% 10.7% 11.3%
Max 87.6% 39.2% 44.9% 91.7% 28.2% 93.3%
Skew 2.8 -1.4 -2.8 5.2 -0.1 4.7
Exc Kurt 33.2 9.5 17.5 50.1 1.9 43.9
Ann SR 0.27 0.60 0.30 0.18 0.08 0.22
Ann CE -68.4% -98.7% -100.0% -21.5% -23.3% -23.3%
Panel B: Time-series weights mean
ATM Call -3.8% -4.5% -3.4% -2.2% -2.3% -1.9%
ATM Put 0.3% 3.5% 5.7% 3.1% 4.9% 5.3%
OTM Call -0.5% -1.0% -0.9% 0.7% 1.0% 1.0%
OTM Put -0.3% -6.3% -6.9% -0.5% -1.9% -1.9%
Min -43.4% -186.9% -104.9% -11.3% -13.3% -17.9%
Max 31.3% 34.0% 49.5% 14.3% 11.4% 14.2%
Sum Abs 7.1% 18.0% 19.2% 6.8% 10.2% 10.4%
Sum Abs Calls 4.8% 6.1% 5.2% 2.9% 3.3% 3.0%
Sum Abs Puts 2.3% 11.9% 14.0% 3.9% 6.9% 7.3%
Panel C: Time-series risk mean
Delta 0.98 0.97 0.97 0.98 0.97 0.97
Elasticity -25.04 -32.39 -36.17 -26.91 -33.88 -33.77
46

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Optimal Option Portfolio Strategies∗

José Afonso Faias1 and Pedro Santa-Clara2

Current version: October 2011

able makes it difficult to estimate the distribution. We propose a method to optimize

option portfolios that solves these limitations. In an out-of-sample exercise, even

Sharpe ratio of 0.50 between January 1996 and October 2010.

We study the performance of our Optimal Option Portfolio Strategies, which we

Hedging demand and long-term considerations can potentially be very important.

A related literature investigates the returns of simple options trading strategies.

Eraker (2007) uses a standard mean-variance framework with a parametric model of

Driessen and Maenhout (2007) analyze the importance of derivatives in portfolio

Constantinides, Jackwerth, and Savov (2009) study portfolios made up of either

II. Portfolio Allocation

Let time be represented by the subscript t and simulations indexed by n. Our

4. We construct simulated portfolio returns in the usual way:

5. We choose weights by maximizing expected utility over simulated portfolio returns

The output is given by ωt,c , c = 1, ..., C and ωt,p , p = 1, ..., P .

Ct+1,c = max(St+1 − Kt,c , 0) and Pt+1,p = max(Kt,p − St+1 , 0) (6)

Second, we find the corresponding returns:

using the weights determined in step 5 above.

1. Simulate standardized returns:

2. Scale the bootstrapped standardized returns by the current standardized return:

C. Maximizing expected utility

where γ is the coefficient of relative risk aversion.9

We incorporate transaction costs by decomposing each option into two “securities”:

B. Construction of options returns

We also compute the certainty-equivalent of an investor with risk aversion of 10

Conditional OOPS returns, however, present positive skewness (around 1) and

To measure the sensitivity of this portfolio to potential changes in the underlying

The second approach involves the use of a mean-variance utility function U = µp −

In a third robustness check, we examine the performance of a representative investors

2. Find the next-period underlying asset value

3.a. Determine simulated option payoffs at maturity

4. Construct the simulated portfolio return

, 2007, An empirical portfolio perspective on option pricing anomalies, Review of

, and Mark Rubinstein, 1996, Recovering probability distributions from option

Jorion, Philippe, 2000, Risk-management lessons from Long-Term Capital Management,

Relative Bid-ask Spread

ATM call ATM put

OTM call OTM put

Unconditional OOPS - Empirical Unconditional OOPS - Normal Unconditional OOPS - GEV

-100 0 100 -100 0 100 -100 0 100

Conditional OOPS - Empirical Conditional OOPS - Normal Conditional OOPS - GEV

-100 0 100 -100 0 100 -100 0 100

Unconditional OOPS Cumulative Returns

Conditional OOPS Cumulative Returns

Raw returns Standardized returns

ATM Call ATM Put OTM Call OTM Put

Exc Ann Ann

Unconditional OOPS Conditional OOPS

Panel A: Time-series weights mean

Panel A: Betas of explanatory regressions rtOOS − rft = α + βXt + t

Panel A: Conditional OOPS - CRRA utility

Panel A: Time-series OOS return

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Panel A: Betas of explanatory regressions rtOOS − rft = α + βXt + t