Estimating the Market's Expected Return and Uncertainty from Option Prices

This paper proposes an option pricing model which can estimate the market’s expected return and the market’s uncertainty of this return while complying with various complex characteristics of real-world markets. First, it is proposed that the market is not homogenous; the market is made up of many independent investors, each with their unique perspectives, forecasts, and levels of conviction. Second, it is proposed that investors are not risk neutral and have non-linear utility functions; the paper borrows an established utility function from behavioral finance. Third, it is shown that most market participants find an asset’s price too high to buy and too low to short; an effective asset pricing model must acknowledge this. Fourth, options prices better reflect the sentiment of those who do not invest than they reflect the sentiment of those who do invest. The model can use a single option price to divide the two-dimensional investor space (x=expected value of underlying at expiration, y=uncertainty of this expected value) into three subspaces – investor buys, investor sells, and investor does nothing. By incorporating prices of multiple options on the same underlying asset with the same expiration date, the model can narrow in on the market’s expected return of the asset