Cross-Section of Option Returns and Volatility

We study the cross-section of stock option return by constructing decile portfolios of straddles and delta-hedged calls and puts based on sorting stocks on the difference between historical realized volatility and at-the-money implied volatility. We find that a zero-cost trading strategy that is long (short) in the portfolio with a large positive (negative) difference between these two volatility measures produces an economically and statistically significant average monthly return. The results are robust to different market conditions, to stock risk-characteristics, to various industry groupings, to option liquidity characteristics, and are not explained by usual risk factor models.