Where Do Options Returns Come From

Key Takeaways

• Individual put returns are noisy, not reliable mispricing signals
• Straddle returns reveal risk premiums beyond Black‑Scholes assumptions
• Returns stem from equity premium amplified by option leverage
• Findings support volatility risk premium as key driver of option profits

Pulse Analysis

Short‑volatility trading has long been justified by the notion of a volatility risk premium, yet many practitioners still question whether options are simply mispriced. The 2009 study by Broadie, Chernov and Johannes provides a rigorous empirical foundation that dispels the mispricing myth. By dissecting the return distribution of single‑leg puts, the authors show that sampling error and skewed payoffs render individual option returns too volatile to serve as reliable signals. This insight redirects attention toward multi‑leg structures, particularly straddles, whose near‑neutral exposure to the underlying isolates the premium component.

Straddles, as the research demonstrates, generate returns inconsistent with classic Black‑Scholes and Heston models when no additional risk premium is assumed. The excess returns align with theories of estimation risk and jump‑risk premiums, suggesting that market participants price in the possibility of abrupt price moves. This nuance matters for portfolio construction: investors seeking pure volatility exposure should favor balanced option portfolios that capture the premium without being contaminated by directional equity risk. Moreover, the study’s linkage of the volatility premium to the equity risk premium—magnified through option leverage—offers a coherent explanation for why short‑volatility strategies can be profitable even in efficient markets.

The broader implication for the industry is a shift from viewing options as mispriced anomalies to recognizing them as vehicles for harvesting a well‑documented risk premium. Asset managers can now justify short‑volatility allocations with a solid theoretical underpinning, improving risk‑adjusted performance metrics and client communication. As markets evolve, incorporating jump‑risk considerations and refined estimation techniques will further enhance the precision of volatility‑premium capture, cementing its role in modern quantitative investing.