Why Do Option Prices Predict Stock Returns? The Role of Price Pressure in the Stock Market
59 Pages Posted: 24 Nov 2015 Last revised: 14 Nov 2017
Date Written: November 14, 2017
Disagreement between the stock and options markets about the stock's value can reflect both informed trading in options and temporary price pressure in stocks. We document that the disagreement is strongly related to return reversals, order imbalances, and illiquidity in stocks, and weakly related to trading in options. We conclude that stock price pressure is the primary driver of disagreement and of the resultant strong option-price based predictability in stock returns. Implied volatility measures previously interpreted as capturing informed trading in options are direct transformations of the price discrepancy between the two markets and similarly capture price pressure in stocks.
Keywords: Price Pressure, Put-Call Parity, Return Predictability, Informed Trading
JEL Classification: G11, G12, C13
Suggested Citation: Suggested Citation