Option Return Predictability with Machine Learning and Big Data
Bali, Turan G.; Beckmeyer, Heiner; Moerke, Mathis; Weigert, Florian
Abstract
Drawing upon more than 12 million observations over the period from 1996 to 2020, we find that allowing for nonlinearities significantly increases the out-of-sample performance of option and stock characteristics in predicting future option returns. The nonlinear machine learning models generate statistically and economically sizable profits in the long-short portfolios of equity options even after accounting for transaction costs. Although option-based characteristics are the most important standalone predictors, stock-based measures offer substantial incremental predictive power when considered alongside option-based characteristics. Finally, we provide compelling evidence that option return predictability is driven by informational frictions and option mispricing.
Keywords
Machine Learning; Option Return Predictability; Limits to Arbitrage