Implied Volatility Sentiment: A Tale of Two Tails

Tinbergen Institute Discussion Paper 17-002/IV

54 Pages Posted: 17 Jan 2017 Last revised: 31 Jan 2018

Luiz F. F. Felix

APG Asset Management

Roman Kräussl

Luxembourg School of Finance; Hoover Institution, Stanford University

Philip A. Stork

VU University Amsterdam - Faculty of Economics and Business Administration; Tinbergen Institute - Tinbergen Institute Amsterdam (TIA)

Date Written: January 26, 2018

Abstract

Low probability events are overweighted in the pricing of out-of-the-money index puts and single stock calls. We show that such a behavioral bias is strongly time-varying and is linked to equity market sentiment and higher moments of the risk-neutral density. We find that our implied volatility (IV) sentiment measure, jointly derived from index and single stock options, explains investors' overweight of tail events well. Our IV-sentiment measure adds value over and above traditional factors in predicting the equity risk premium out-of-sample. When employed as a mean-reversion strategy, our IV-sentiment measure delivers economically significant results, which are more consistent than the ones produced by the conventional sentiment factor. We find that our contrarian investment strategy shows limited exposure to a set of cross-sectional equity factors, including Fama and French's five factors, the momentum factor and the low-volatility factor, and seems valuable in avoiding momentum crashes.

Keywords: Sentiment, implied volatility skew, equity-risk premium, reversals, predictability, momentum crashes

JEL Classification: G12, G14, G17

Suggested Citation

Felix, Luiz F. F. and Kräussl, Roman and Stork, Philip A., Implied Volatility Sentiment: A Tale of Two Tails (January 26, 2018). Tinbergen Institute Discussion Paper 17-002/IV . Available at SSRN: https://ssrn.com/abstract=2899680 or http://dx.doi.org/10.2139/ssrn.2899680

Luiz F. F. Felix (Contact Author)

APG Asset Management ( email )

Gustav Mahlerplein 3
Amsterdam, 1082 MS
Netherlands

Roman Kraeussl

Luxembourg School of Finance ( email )

4, rue Albert Borschette
Luxembourg, 1246
Luxembourg
+3524666445442 (Phone)

HOME PAGE: http://www.art-finance.com

Hoover Institution, Stanford University ( email )

Stanford, CA 94305
United States

Philip A. Stork

VU University Amsterdam - Faculty of Economics and Business Administration ( email )

De Boelelaan 1105
Amsterdam, 1081HV
Netherlands

Tinbergen Institute - Tinbergen Institute Amsterdam (TIA) ( email )

Gustav Mahlerplein 117
Amsterdam, 1082 MS
Netherlands

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