Improving Portfolio Selection Using Option-Implied Volatility and Skewness

in Journal of Financial and Quantitative Analysis (2013), 48(06), 1813-1845

Our objective in this paper is to examine whether one can use option-implied information to improve the selection of mean-variance portfolios with a large number of stocks, and to document which aspects ... [more ▼]

Our objective in this paper is to examine whether one can use option-implied information to improve the selection of mean-variance portfolios with a large number of stocks, and to document which aspects of option-implied information are most useful to improve their out-of-sample performance. Portfolio performance is measured in terms of volatility, Sharpe ratio, and turnover. Our empirical evidence shows that using option-implied volatility helps to reduce portfolio volatility. Using option-implied correlation does not improve any of the metrics. Using option-implied volatility, risk premium, and skewness to adjust expected returns leads to a substantial improvement in the Sharpe ratio, even after prohibiting short sales and accounting for transaction costs. [less ▲]