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Why Do Option Prices Predict Stock Returns? The Role of Price Pressure in the Stock Market

91 Pages Posted: 24 Nov 2015 Last revised: 3 Nov 2016

Luis Goncalves-Pinto

Chinese University of Hong Kong - Department of Finance

Bruce D. Grundy

University of Melbourne

Allaudeen Hameed

National University of Singapore (NUS) - Department of Finance

Thijs van der Heijden

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

Yichao Zhu

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Applied Statistics

Date Written: November 2, 2016

Abstract

We show that option-based predictors of stock returns, such as implied-volatility spreads, skews, and changes therein, are significantly affected by price pressure in the stock market not reflected in option prices. These option-based predictors are transforms of the difference between the option-implied stock value and the traded stock price (DOTS). We find that DOTS is strongly related to return reversals, order imbalances, and illiquidity in stocks, but is only weakly related to trading activity in options. This suggests that price pressure in stocks is an important driver of the stock return predictability derived from option prices.

Keywords: Price Pressure, Put-Call Parity, Return Predictability, Informed Trading

JEL Classification: G11, G12, C13

Suggested Citation

Goncalves-Pinto, Luis and Grundy , Bruce D. and Hameed, Allaudeen and van der Heijden, Thijs and Zhu, Yichao, Why Do Option Prices Predict Stock Returns? The Role of Price Pressure in the Stock Market (November 2, 2016). FIRN Research Paper No. 2695145. Available at SSRN: https://ssrn.com/abstract=2695145 or http://dx.doi.org/10.2139/ssrn.2695145

Luis Goncalves-Pinto

Chinese University of Hong Kong - Department of Finance ( email )

Cheng Yu Tung Building
Shatin
Hong Kong
Hong Kong

Bruce D. Grundy

University of Melbourne ( email )

Faculty of Economics & Commerce
Department of Finance
Victoria, 3010
Australia
+61 3 8344 9083 (Phone)
+61 3 8344 6914 (Fax)

Allaudeen Hameed

National University of Singapore (NUS) - Department of Finance ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore

HOME PAGE: http://www.bschool.nus.edu.sg/staff_profile/cv.asp?ID=3

Thijs Van der Heijden (Contact Author)

University of Melbourne - Department of Finance ( email )

198 Berkeley Street
Carlton VIC 3010
Australia

Financial Research Network (FIRN)

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

HOME PAGE: http://www.firn.org.au

Yichao Zhu

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Applied Statistics ( email )

Kingsley st.
acton, ACT 0200
Australia

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