Do informed options traders know more than other traders? In other words, are there reliable and exploitable predictive relationships between changes in implied volatility and future returns for associated stocks? In the February 2012 version of their paper entitled “The Joint Cross Section of Stocks and Options”, Andrew Ang, Turan Bali and Nusret Cakici investigate the relationship between changes in implied volatility and stock returns for individual stocks. They consider both call-implied and put-implied volatilities based on near-term expirations. Using daily implied volatilities, associated daily stock prices and firm accounting data for a broad sample of U.S. stocks over the period January 1996 through September 2008 (153 months), they conclude that:
- Stocks with large increases in call-implied (put-implied) volatilities tend to rise (fall) over the next month. Specifically:
- The spread in average next-month gross returns and between the highest and lowest equally weighted quintiles formed monthly by ranking the entire sample on changes in call-implied volatilities is 0.97%. Controlling for common risk factors and firm characteristics modestly reduces these returns.
- A double ranking first on changes in put-implied volatility for the entire sample and then on changes in call-implied volatilities within the lowest put-ranked quintile enhances this spread. (See the chart below.)
- While strongest for a one-month horizon, predictability persists for at least three months.
- Conversely, options for stocks with high returns over the past month tend to have increases in call-implied volatility over the next month, with an abnormal stock return of 1% implying an increase in call-implied volatility of about 2%.
- The predictive power of changes in implied volatilities for stock returns stems from idiosyncratic, not systematic, volatility. In other words, the predictive relationship derives from information about the stock and not information about the market.
- Results hold across subperiods and for the 2008 financial crisis, during which the predictive relation between large increases in put volatility and future low stock returns is prominent.
- Results are consistent with the presence of informed traders in both the equity and options markets, with slow inter-market information diffusion.
The following figure, constructed from data in the paper, shows the average next-month gross returns for two sets of equally weighted quintile portfolios formed monthly over the entire sample period. One set derives from ranking the entire sample on the monthly change in call-implied volatility. The other derives from ranking first on the monthly change in put-implied volatility and then ranking the lowest resulting quintile on the monthly change in call-implied volatility. Results indicate that: (1) the larger the change in call-implied volatility, the larger the expected stock return; and, (2) combining the information in changes in put-implied and call-implied volatilities may enhance power to predict stock returns.
In summary, evidence suggests that investors may be able to gain an edge from the power of changes in implied volatilities to predict returns for individual stocks, and the power of stock returns to predict future changes in implied volatilities.
Cautions regarding findings include:
- Reported returns are gross, not net. Including reasonable trading frictions would reduce these returns. Trading frictions may increase with changes in implied volatilities.
- Data snooping bias associated with the large number of portfolio rule combinations may be material.
- Data collection and portfolio construction may be beyond the reach of many investors.
