Do Option-Based Measures of Stock Mispricing Find Investment Opportunities or Market Frictions?

Abstract

This paper considers a plethora of option-based measures of stock mispricing introduced by previous literature. These measures are based on differences between implied and actual stock prices, differences in implied volatilities across options, and on option trading volume. We show that stocks that these measures indicate are mispriced are small and/or hard to borrow. When small and hard-to-borrow stocks are omitted, returns to short selling are insignificant for some of the measures and greatly diminished for others. Three of the nine measures, however, predict positive abnormal stock returns for value-weighted portfolios without obvious market frictions, suggesting that they constitute investment opportunities.

Keywords: options implied stock prices, expiration risk, stock return predictability

JEL Classification: G14