The Idiosyncratic Volatility Puzzle and its Interplay with Sophisticated and Private Investors

Abstract

We establish a direct link between the idiosyncratic volatility (IVol) puzzle and the behavior of sophisticated and private investors. To do so, we employ three option-based measures of informed trading and attention data from Google Trends. Our analyses show that the IVol puzzle is particularly driven by a group of overpriced stocks that can be identified by the use of sophisticated trader opinion. Since IVol is no perfect mispricing indicator, the option measures can help to distinguish high-IVol stocks that are overvalued from high-IVol stocks that are not exposed to mispricing. We link the origin of the anomaly to the trading activity of irrational private investors. This supports the intuitive idea that noise trading leads to mispricing which can be exploited by sophisticated investors at the option market.

Keywords: Demand-Based Option Pricing, Idiosyncratic Volatility, Investor Attention

JEL Classification: G12, G14, G40