Why Does Options Market Information Predict Stock Returns?

Abstract

Several influential studies show that options volatilities and trading volume predict stock returns. This predictability is puzzling because market participants can readily observe options market
data. We find that this predictability is consistent with option prices reflecting stock borrow fees
that are known to predict stock returns. We derive a formula relating the option-implied volatility
spread to the borrow fee. Motivated by this relation, we show that abnormal stock return predictability from option signals decreases by about two-thirds after returns are adjusted for
borrow fees. The predictability of unadjusted returns decreases by a similar amount if high-fee
stocks are excluded.

Keywords: equity options, put-call parity, implied volatility spread, implied volatility skew, stock borrowing fee, stock lending fee

JEL Classification: G12, G13, G14