Why Do Options Prices Predict Stock Returns?
49 Pages Posted: 25 Feb 2014
Date Written: July 1, 2013
We use a new approach to assess the information transmission between options and stock markets. We study whether the predictive power of option-implied volatilities (IVs) on stock returns lies in analyst-related and/or earnings-related news. We find that two proxies for options trading (IV skew and IV spread) predict analyst recommendation changes, analyst forecast revisions, and earnings surprises. Next, we show that the IV skew and IV spread predict stock returns, and that the degree of predictability more than doubles around analyst-related and earnings-related events. Additionally, we find that informed traders choose to use the options market particularly because of short-sale constraints on the underlying stock. We also find that the informed options trading increases with the options market liquidity.
Keywords: Informed traders, corporate events, implied volatility spread, implied volatility skew, short-sale constraint
JEL Classification: G12, G14, G17
Suggested Citation: Suggested Citation