March 20, 2014 - Equity Options
Do implications of equity option prices predict returns for underlying stocks? In their December 2013 paper entitled “Option-Implied Volatility Measures and Stock Return Predictability” Xi Fu, Eser Arisoy, Mark Shackleton and Mehmet Umutlu compare the abilities of various option-implied volatility metrics to predict returns for individual stocks at horizons of one to three months. Specifically, they consider:
- Call-Put Implied Volatility spread (CPIV): difference between at-the-money call and at-the-money put implied volatilities.
- Implied Volatility Skew (IVSKEW): difference between out-of-the-money put and at-the-money call implied volatilities.
- Above-Minus-Below (AMB): difference between average of in-the-money put and out-of-the-money call implied volatilities and average of in-the-money call and out-of-the-money put implied volatilities.
- Call Out-Minus-At (COMA): difference between out-of-the-money call and at-the-money call implied volatilities.
- Put Out-Minus-At (POMA): difference between out-of-the-money put and at-the-money put implied volatilities.
- Realized Volatility-Implied Volatility spread RVIV): difference between realized volatility (annualized standard deviation of daily returns over the previous month) and implied volatility.
Each month, they rank stocks into quintiles based on each of these six metrics. They then form respective capitalization-weighted and equal-weighted hedge portfolios that are long (short) the quintiles with the highest (lowest) values of each metric and hold for one month. They also perform regressions to control portfolio returns over one, two and three months for a variety of market, stock and option characteristics. Using firm financial statement data, monthly and daily stock returns and monthly option-implied volatilities (from options with maturities of one to three months) during February 1996 through December 2011 (191 months), they find that: Keep Reading