This paper studies the determinants of delta-hedged equity option returns both theoretically and empirically. I first use a Merton-type structural model to identify two theoretical determinants of the delta-hedged equity option returns, i.e. financial leverage and asset volatility. The theory suggests that the relation between the determinants and the delta-hedged equity option returns is nonlinear. Empirically I find that these two structural variables can explain a large portion of the cross-sectional variation in the data and even subsume information in other determinants documented in the literature, such as idiosyncratic volatility and liquidity. The results of double sorting exercise are consistent with the theory. There is also evidence of the nonlinear relation between the determinants and the delta-hedged equity option returns: the determinants affect positive and negative returns differently. These findings are robust across calls, puts and different moneyness levels.

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