Implied Volatility Changes as Evidence of Stock Price Disequilibrium
Posted: 21 May 2019
Date Written: January 1, 2016
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: Suggested Citation