Momentum in the Option Market

In the financial market, momentum is the tendency for assets to continue moving in the same direction. It is a reflection of the underlying strength or weakness of an asset’s price action and can be used to identify trends. Momentum is one of the most pervasive market phenomena and can be observed in nearly all the stock markets around the world.

Does this anomaly exist in other asset classes?

Reference [1] studied momentum in the options market. It examined the returns of delta-neutral straddles on individual equities. The article pointed out,

Most significantly, option returns display momentum, meaning that firms whose options performed well in the previous 6 to 36 months are likely to see high option returns in the next month as well. Momentum is present whether we measure past performance on a relative basis (“cross- sectional momentum”) or an absolute basis (“time series momentum”). It is profitable in every five-year subsample and is far less risky than short straddle positions on the S&P 500 Index or individual stocks. Further, returns to these strategies show no evidence of the momentum crashes that periodically affect stocks, though it is possible that our sample is too short to detect such phenomena…

Though less robust to controls and methodology, we also find evidence of short-term cross-sectional reversal in option returns, in that firms with options that perform relatively well in one month tend to have options that perform relatively poorly in the next month…We find no evidence of long-run reversal in option returns, which is in stark contrast to the behavior of stocks. Moreover, at the 2- to 3-year horizons at which stocks start showing a tendency to reverse, option returns continue to show momentum.

In short, like in equities, options also exhibit momentum. The options momentum is mean-reverting in the short term and trending in the long term.

The authors also argued that the options momentum is different from stock momentum,

Because we work with delta-hedged option positions, our results are unexplained by stock momentum. The profitability of the strategy is also unaffected by controlling for other option characteristics, such as the difference between implied and historical volatilities, and is also robust to adjustment using factors constructed from these characteristics.

We find the article insightful, but we don’t agree with this point. Since the PnL of a delta-hedged straddle relates to the trending/mean-reverting property of the underlying stock, there should be a strong connection between the stocks and options momentum.

Let us know what you think in the comments below.

References

[1] Heston, Steven L. and Jones, Christopher S. and Khorram, Mehdi and Li, Shuaiqi and Mo, Haitao, Option Momentum (2022). https://ssrn.com/abstract=4113680