Implied Volatility Changes as Evidence of Stock Price Disequilibrium

Posted: 21 May 2019

Date Written: January 1, 2016

Abstract

Past works have documented the predictive power of short-term stock return momentum and option volume ratios for future stock returns. We find option volume ratios have greater power to predict future returns when evidence prices are out of equilibrium exists, proxied for by increases in implied volatility. In our sample, short-term momentum has significant power to predict future stock returns only in the presence of evidence prices are out of equilibrium. We document that option volume ratios, changes in option implied volatility and short-term momentum, together, have significant predictive power for the cross-section of stock returns in subsequent periods. The difference between firms predicted to be strong performers and those predicted to be weak performers is more than 1% per month. Buy and hold returns for an equally weighted portfolio of predicted strong performers are 249% over the 1996-2009 period compared to a loss of 38% for predicted weak performers. S&P 500 returns over the same period were 60%.

Keywords: option volume, implied volatility, short-term momentum, stock returns, disequilibrium

JEL Classification: G11, G12, G13

Suggested Citation

Diavatopoulos, Dean and Fodor, Andy, Implied Volatility Changes as Evidence of Stock Price Disequilibrium (January 1, 2016). Journal of Investing, Forthcoming, https://doi.org/10.3905/joi.2017.26.3.129, Available at SSRN: https://ssrn.com/abstract=2940547

Dean Diavatopoulos (Contact Author)

Seattle University ( email )

901 12th Avenue
Seattle, WA 98122
United States

Andy Fodor

Ohio University ( email )

514 Copeland Hall
Athens, OH 45701
United States
740.593.0259 (Phone)

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