A New Index of Option Implied Absolute Deviation

Abstract

This paper proposes a new index of forward looking absolute deviation extracted from option prices. The new index, named ADIX, is model-free and easy to compute using at-the-money straddle prices. An empirical analysis using S&P 500 options data for the time period 1996-2019 reveals that ADIX embeds useful information for forecasting future realized volatility and future returns. The term structure of ADIX is consistent with the expectations hypothesis and short-term ADIX is economically significant and outperforms VIX in a mean-variance asset allocation exercise. The new index offers an alternative risk measure, more intuitive as a measure of dispersion, to study information embedded in option prices.

Keywords: straddle, option implied absolute deviation

JEL Classification: G12, G13