Predictable Stock Returns, Transaction Costs, and the (Un)Informativeness of Option Prices

Abstract

We argue that the ability of option prices to predict future stock returns stems from the interaction between transaction costs and stock returns that are ex-ante predictable using public signals from the stock market itself. Empirically, we find that the option price-based predictors only work consistently when they agree with the stock-based predictors, notwithstanding the nearly zero correlation between them. Moreover, this option-based predictability is stronger in negative stock markets, when stock-based predictability and illiquidity are both stronger. Directional option trading cannot explain these results, suggesting that they are unlikely driven by trading on private signals or superior ability of option traders to process public information. We demonstrate that our empirical findings are consistent with the implications of a parsimonious option pricing model that accounts for predictable stock returns and transaction costs. Overall, our results significantly weaken the extent to which this cross-market predictability can be attributed to the informational advantage of option traders.

Keywords: Put-Call Parity, Predictable Stock Returns, Trading Costs, Informed Trading

JEL Classification: G11, G12, C13