Do Option Characteristics Predict the Underlying Stock Returns in the Cross-Section?

Abstract

We provide the first comprehensive analysis of options-implied information for predicting the cross-section of stock returns. Based on an extensive set of both firm and option characteristics and using traditional portfolio sorts and modern high-dimensional methods, we find that option information matters. However, in contrast to existing studies, there are only a few option characteristics that have significant incremental predictive power after controlling for the large set of firm characteristics. Further structural analysis reveals that the strongest option characteristics are associated with asset mispricing, future tail return realizations and short-selling costs. Our findings are consistent with models of informed trading and limits to arbitrage.

Keywords: Asset Pricing, Factor Models, High-dimensional Methods, Option-implied Risk

JEL Classification: C13, C14, G11, G12, G14