A Factor Model for Stock Options

We propose a theoretically motivated and empirically robust factor model for option returns. The model consists of factors based on option illiquidity, option price, implied-minus-realized volatility, implied-minus-realized skewness, implied-minus-realized kurtosis, and the option market factor. We find that the model has a higher tangent portfolio Sharpe ratio than extant factor models and outperforms such models in explaining the returns of a larger number of test assets. We also show that the stochastic discount factor implied by the newly proposed model captures greater risk-return opportunities available in the options market and improves the cross-sectional pricing of individual equity options.