Implied Volatility Sentiment: A Tale of Two Tails
Revised version: Forthcoming, Quantitative Finance. This version: Tinbergen Institute Discussion Paper 17-002/IV
54 Pages Posted: 17 Jan 2017 Last revised: 3 Dec 2019
Date Written: January 26, 2018
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: Suggested Citation