Why Do Options Prices Predict Stock Returns?

49 Pages Posted: 25 Feb 2014

See all articles by Tse-Chun Lin

Tse-Chun Lin

The University of Hong Kong - Faculty of Business and Economics

Xiaolong Lu

The University of Hong Kong - Faculty of Business and Economics

Joost Driessen

Tilburg University - Tilburg University School of Economics and Management; Tilburg University - Center for Economic Research (CentER)

Date Written: July 1, 2013

Abstract

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

Lin, Tse-Chun and Lu, Xiaolong and Driessen, Joost, Why Do Options Prices Predict Stock Returns? (July 1, 2013). Netspar Discussion Paper No. 07/2013-079. Available at SSRN: https://ssrn.com/abstract=2400955 or http://dx.doi.org/10.2139/ssrn.2400955

Tse-Chun Lin

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

Xiaolong Lu

The University of Hong Kong - Faculty of Business and Economics ( email )

Rm1122, KK Leung Building
Pokfulam Road
Hong Kong
China

Joost Driessen (Contact Author)

Tilburg University - Tilburg University School of Economics and Management ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

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