Slow Diffusion of Information and Price Momentum in Stocks: Evidence from Options Markets

39 Pages Posted: 13 Oct 2013 Last revised: 27 Sep 2016

See all articles by Zhuo Chen

Zhuo Chen

Tsinghua University; Tsinghua University - PBC School of Finance

Andrea Lu

The University of Melbourne - Department of Finance; Financial Research Network (FIRN)

Date Written: September 20, 2016

Abstract

This paper investigates the source of price momentum in the stock market using information from options markets. We provide direct evidence of the gradual information diffusion model in Hong and Stein (1999): momentum profits are larger for stocks whose information diffuses slowly into the stock market. We exploit the options markets to identify stocks with slow information diffusion speed. As informed traders trade options to realize the information that has not been fully incorporated in the stock price, we are able to enhance the momentum strategy by selecting winner/loser stocks with high growth/large drop in call option implied volatility. Our empirical strategy generates a risk-adjusted alpha of 1.8\% per month over the 1996--2011 period, during which the simple momentum strategy fails to perform. The results are robust to the impact of earnings announcement, transaction costs, industry concentration, and choice of options' moneyness and time-to-maturity. Finally, our finding is not driven by existing stock- or option-related characteristics that are known the improve momentum.

Keywords: Momentum, Implied Volatility

JEL Classification: G10, G11, G12, G13

Suggested Citation

Chen, Zhuo and Lu, Andrea Y., Slow Diffusion of Information and Price Momentum in Stocks: Evidence from Options Markets (September 20, 2016). PBCSF-NIFR Research Paper No. 13-03. Available at SSRN: https://ssrn.com/abstract=2339711 or http://dx.doi.org/10.2139/ssrn.2339711

Zhuo Chen (Contact Author)

Tsinghua University ( email )

43 Chengfu Road
Beijing, 100083
China

Tsinghua University - PBC School of Finance

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

Andrea Y. Lu

The University of Melbourne - Department of Finance ( email )

Level 12, 198 Berkeley Street
Parkville, Victoria 3010 3010
Australia
+61383443326 (Phone)
+61383446914 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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