The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

RISK AND EXPECTED RETURN OF OPTION STRATEGIES

Options are like any other risky asset because they compensate investors for assuming systematic risk. Therefore, if options have higher exposure to systematic risk, investors will require and expect higher returns from holding options. Naturally, call options, which pay off in states of the world where the underlying asset’s price rises, will have higher expected returns than the underlying asset. In contrast, put options, which pay off in states of the world where the asset’s price declines, will have lower expected returns than the risk-free asset that are often negative.²⁷² Furthermore, adding options to a stock portfolio or writing options against an existing long position will change the risk-return characteristics of the investment and therefore its expected return.

According to the asset pricing framework of Merton and the Black Scholes model, the instantaneous expected return to an option ought to be the same as the return implied by the CAPM.²⁷³ Hence, it can be shown that an option’s instantaneous beta is related to the beta of the underlying stock and the elasticity of the option.²⁷⁴ Rendleman demonstrates that the expected returns and risks for options should be consistent with the principles of risk and return from the CAPM.²⁷⁵ He shows the impact on expected returns for various investment strategies that use options. One observation is that call options with high positive betas should have high expected returns and ...