Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?

Abstract:     
This paper examines the relation between net buying pressure and the shape of the implied volatility function (IVF) of S&P 500 index options and options on twenty individual stocks. We find that time variation in the implied volatility of an option series is directly related to net buying pressure from public order flow. We also find that movements in implied volatility in the index option market are most strongly affected by buying pressure for index puts, while call options tend to dominate in stock option markets. Simulated delta-neutral trading strategies that sell options generate abnormal returns that match the deviations of the IVFs from historical volatility levels. Index option abnormal returns decrease monotonically across exercise prices and are significant, while stock option abnormal returns are symmetric, smaller, and insignificant. When vega risk is also hedged in the simulations using index options, however, the abnormal returns go from positive to negative, indicating that the steeply sloped IVF for index options does not present a profitable arbitrage opportunity once the costs of hedging have been considered.

Keywords: Option valuation, market efficiency, limits to arbitrage

JEL Classifications: G13, G14

Working Paper Series