Implied Correlation and Cross-Section of Option Returns

Are correlation shocks priced in the cross-section of option returns? We examine the cross-section of stock option returns by sorting stocks based on their exposure to correlation shocks. We find that a zero-cost long-short trading strategy in portfolio option returns sorted on the underlying asset’ exposure to high correlation, produces an economically and statistically significant average monthly return. Even after controlling for standard risk factors in the option market and taking into account transaction costs, the strategy leads to positive and significant returns. Our findings provide support that rises in stock market correlation reveals an increase in aggregate risk aversion, so that investors use the option markets for hedging purposes in such periods.