Option Prices as Predictors of Aggregate Stock Returns

Abstract

The relative prices of S&P 500 index call and put options convey information regarding the future return of the S&P 500 index realized over the life of the options. When call options are relatively more expensive than put options, the index earns higher returns. Specifically, the natural log of the ratio of the out-of-the-money call price to the equally out-of-the-money put price at differing moneyness levels and maturities is positively related to the return of the index realized over the life of the options. This predictability is robust to controls for the cost of carry, past returns, implied volatility, and upper moments of the underlying. Furthermore, the results do not appear to be driven by the sign of the log ratio. Portfolios of the underlying formed when the log ratio of the options prices is positive (when call options are more expensive) statistically outperform portfolios similarly formed when the log ratio is negative (when put options are more expensive).

Keywords: Future returns, predictability, option values, cubic spline, implied volatility

JEL Classification: G12, G13