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

68 Pages Posted: 9 Aug 2016 Last revised: 6 Feb 2021

See all articles by Luis Goncalves-Pinto

Luis Goncalves-Pinto

University of New South Wales (UNSW)

Jing Xu

Renmin University of China - School of Finance

Date Written: February 6, 2021

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

Suggested Citation

Goncalves-Pinto, Luis and Xu, Jing, Predictable Stock Returns, Transaction Costs, and the (Un)Informativeness of Option Prices (February 6, 2021). 29th Australasian Finance and Banking Conference 2016, Asian Finance Association (AsianFA) 2018 Conference, Available at SSRN: https://ssrn.com/abstract=2820422 or http://dx.doi.org/10.2139/ssrn.2820422

Luis Goncalves-Pinto (Contact Author)

University of New South Wales (UNSW) ( email )

Kensington
High St
Sydney, NSW 2052
Australia

HOME PAGE: http://luis.goncalvespinto.com/

Jing Xu

Renmin University of China - School of Finance ( email )

59 Zhongguancun Street
Beijing, 100872
China

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