What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?

38 Pages Posted: 26 Mar 2008 Last revised: 15 Aug 2008

Xiaoyan Zhang

Purdue University - Krannert School of Management; Tsinghua University - PBC School of Finance

Rui Zhao

BlackRock, Inc.

Yuhang Xing

Rice University

Date Written: August 14, 2008

Abstract

The shape of the volatility smirk has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 10.9% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with the steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to trade out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.

Keywords: stock return predictability, option-implied volatility smirks, cross-sectional asset pricing

JEL Classification: G11, G12, G14

Suggested Citation

Zhang, Xiaoyan and Zhao, Rui and Xing, Yuhang, What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns? (August 14, 2008). AFA 2009 San Francisco Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1107464 or http://dx.doi.org/10.2139/ssrn.1107464

Xiaoyan Zhang

Purdue University - Krannert School of Management ( email )

403 WEST STATE STREET
West Lafayette, IN 47907-1310
United States
7654967674 (Phone)

HOME PAGE: http://web.ics.purdue.edu/~zhang654/

Tsinghua University - PBC School of Finance

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

Rui Zhao

BlackRock, Inc. ( email )

55 East 52nd Street
New York City, NY 10055
United States
2128105015 (Phone)
2128108764 (Fax)

Yuhang Xing (Contact Author)

Rice University ( email )

6100 South Main Street
Houston, TX 7705-1892
United States

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