The Joint Cross Section of Stocks and Options

Abstract

Option volatilities have significant predictive power for the cross section of stock returns and vice versa. Stocks with large increases in call implied volatilities tend to rise over the following month whereas increases in put implied volatilities forecast future decreases in next-month stock returns. The spread in average returns and alphas between the first and fifth quintile portfolios formed by ranking on lagged changes in implied call volatilities is approximately 1% per month. Going in the other direction, stocks with high returns over the past month tend to have call option contracts that exhibit increases in implied volatility over the next month, but realized volatility tends to decrease. The results are consistent with the slow diffusion of information across option and underlying equity markets and are suggestive of informed trading occurring in both asset markets.

Keywords: implied volatility, risk premiums, return predictability, momentum

JEL Classification: G10, G11, C13