This paper examines the expected returns of a family of option trading strategies on individual stocks to test whether the (projected) stochastic discount factor (SDF) is monotonic in the terminal stock price. We characterize a class of option trading strategies whose expected returns are increasing in the strike price under a monotonic SDF. Call and put options are special cases, but the set also includes butterfly spreads, bullish call spreads, and binary options. Based on our empirical

more »

... s, we find that expected returns are increasing in the strike price for all the option trading strategies considered in this paper which is consistent with a monotonic SDF. The framework outlined in this paper can be used to test classes of asset pricing models like the CAPM, representative agent models with expected utility and the Black-Scholes model. JEL classification: G12, G13, C8, C50