A Smiling Bear in the Equity Options Market and the Cross-Section of Stock Returns
46 Pages Posted: 20 Jul 2015 Last revised: 19 Oct 2018
Date Written: October 16, 2018
We propose a measure for the convexity of an option-implied volatility curve, IV convexity, as a forward-looking measure of excess tail-risk contribution to the perceived variance of underlying equity returns. Using equity options data for individual U.S.-listed stocks during 2000-2013, we find that the average return differential between the lowest and highest IV convexity quintile portfolios exceeds 1% per month, which is both economically and statistically significant on a risk-adjusted basis. Our empirical findings indicate the contribution of informed options trading to price discovery in terms of the realization of tail-risk aversion in the stock market.
Keywords: Implied volatility, Convexity, Equity options, Stock returns, Predictability
JEL Classification: G12; G13; G14
Suggested Citation: Suggested Citation