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Smirking Because They Know Something?

| | Posted in: Equity Options, Volatility Effects

Does the degree to which out-of-the-money (OTM) put options are “overpriced” imply future returns for associated stocks? In other words, are options traders especially well-informed? In their March 2008 paper entitled “What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?”, Xiaoyan Zhang, Rui Zhao and Yuhang Xing test whether option prices for individual stocks contain important information for the underlying equities. They focus on the predictive power of volatility smirks, the difference between the implied volatilities of OTM put options and at-the-money (ATM) call options. Using daily option and underlying stock price data for all firms with listed options during 1996-2005, they conclude that:

  • Over 90% of sample observations have positive volatility smirks, with OTM put options typically (median) implying volatilities about 5% higher than those implied by ATM call options.
  • A portfolio that is long (short) the tenth of stocks with the least (most) pronounced option volatility smirks, rebalanced weekly, generates a risk-adjusted (market, size, book-to-market) annual return of about 15% before transaction costs.
  • This predictability persists with generally diminishing returns for holding (rebalancing) periods up to about six months.
  • Combining a rough approximation of transactions costs with bimonthly portfolio rebalancing suggests that a real trading strategy may well be profitable.
  • Firms with steepest option volatility smirks tend to have the worst earnings shocks the next quarter.
  • Predictability is robust to size, book-to-market, idiosyncratic volatility and momentum effects.
  • Results are consistent with an interpretation that: (1) informed traders with bad news prefer OTM put options; and, (2) the stock market is slow to incorporate the information they reveal.

In summary, investors/traders may be able to discover economically significant views of informed traders on individual stocks by examining the degree to which the associated option prices smirk.

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