The Joint Cross Section of Option and Stock Returns Predictability with Big Data and Machine Learning

Abstract

Which market has leading informational advantage: stocks or options? Using large set of stock
and option characteristics, and machine learning, we provide a comprehensive analysis of which
characteristics are the first order importance predictors of option and stock returns. First, we find
that option, rather than stock, characteristics are dominant predictors of option returns. Second, option, rather than stock, characteristics are also dominant predictors of stock returns. Consistent with the argument that an increase in trading activity in derivatives decreases information asymmetry about the underlying, option illiquidity is identified as the most important predictor of both stock and option
returns.

Keywords: Machine learning, Option pricing, Stock return predictability

JEL Classification: G10, G12, G13, G14