Is there exploitable feedback between stock returns and behaviors of associated options due to concentration of informed traders in one market or the other? In the October 2013 version of their paper entitled “The Joint Cross Section of Stocks and Options”, Byeong-Je An, Andrew Ang, Turan Baliand and Nusret Cakici investigate lead-lag relationships between stock returns and changes in associated option-implied volatilities. In case there is some asymmetry, they examine call option and put option implied volatilities separately. They focus on near-term options with delta of 0.5 and expiration in 30 days. Using daily stock returns and associated call and put option implied volatilities (available from OptionMetrics), firm fundamentals and risk adjustment factors during January 1996 through December 2011, they find that:
- Stocks with large increases in call (put) implied volatilities over the previous month tend to have high (low) future returns. Specifically:
- The tenth (decile) of stocks with the highest last-month changes in call option implied volatility outperform the decile with the lowest changes next month by about 1% on average based on both raw and risk factor-adjusted (market, size, book-to-market, momentum, liquidity) returns. A strategy that each month buys (sells) the decile with the highest (lowest) changes in call option implied volatility generates a gross annualized Sharpe ratio of 0.90.
- The decile of stocks with the highest last-month changes in put option implied volatility underperform the decile with the lowest changes next month by about 0.4% on average based on both raw and risk factor-adjusted returns.
- Combining changes in call option and put option implied volatilities via double sorts or differences between them boosts average gross monthly returns for extreme long-short decile portfolios to 1.4% and 1.7%, respectively.
- The ability of changes in option-implied volatilities to predict stock returns persists several months. but strength of predictability drops by half after one month.
- The ability of changes in option-implied volatilities to predict stock returns is robust across subperiods, including one including the 2008-2009 financial crisis. Predictability is strongest when both stock and option market volumes are largest.
- Conversely, call option and put option implied volatilities of stocks with high last-month returns tend to increase next month, but with decreasing realized volatility. Specifically, call (put) implied volatilities of stocks that outperform the market by 1% last month tend to increase by about 4% (2%) next month.
In summary, evidence indicates that investors may be able to exploit the ability of monthly changes in call option and put option implied volatilities to predict returns of associated stocks at a one-month horizon.
Cautions regarding findings include:
- Reported returns are gross, not net. High monthly turnover would drive material trading frictions. Shorting may be costly and sometimes infeasible for long-short portfolios.
- Calculation of net profitability should include the cost of implied volatility data.
- The study does not explore whether the ability of stock returns to to predict call and put implied volatilities is exploitable via option portfolios.
