Option Prices Leading Equity Prices: Do Option Traders Have an Information Advantage?

Abstract:     
Recent evidence shows that option volatility skews and volatility spreads between call and put options predict equity returns. This study investigates whether such predictive ability is driven by option traders’ information advantage. We examine the predictive ability of volatility skews and volatility spreads around significant information events including earnings announcements, other firm-specific information events, and events that trigger significant market reactions. Consistent with option traders having an information advantage relative to equity traders before information events, we find that the option measures immediately before these events have higher predictive ability for short-term event returns than they do in a more dated window or before a randomly selected pseudo-event. We also find that option measures have predictive ability after information events. However, this predictive ability holds only for unscheduled corporate announcements, which suggests that, relative to equity traders, option traders have superior ability to process less anticipated information.

Number of Pages in PDF File: 48

working papers series