Is There Predictive Power In The Option-Implied Volatility Smirk?

Apparently, the answer is yes. Xiaoyan Zhang (of Cornell), Rui Zhao (of Blackrock Inc.), and Yuhang Xing (of Rice University) recently conducted a study titled "What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?" Here's their abstract (emphasis mine):

The shape of the volatility smirks has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 15% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to buy out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.

Basically, they calculate the "volatility smirk" (the difference between the implied volatility for At-The-Money (ATM) calls and Out-of-The-Money (OTM) puts) for individual stocks. They then sort firms into portfolios based on deciles of the smirk, and compare returns for the various portfolios (or for "hedge portfolios" constructed by shorting the "high smirk" decile and going long the "low smirk" decile) . The logic for this approach is the hypothesis that informed traders with negative news will choose to buy OTM puts, thereby causing a divergence in the IV of the puts vs for the call.

All in all, a pretty cool paper showing how information flows across markets. Given some work I'm doing with options data, I found it to be particularly timely.

Read the whole thing here.

HT: CXO Advisory Group

Biases in Implied Volatilities

There's a pretty substantial literature on biases in analyst's earnings forecasts. They usually define bias as a difference between the last estimated forecast of earnings and actual earnings. Here's a somewhat related paper - on errors in implied volatility estimates. In their paper "Implied and Realized Volatility in the Cross-Section of Equity Options" Manuel Ammann, David Skovmand and Michael Verhofen examine whether implied volatilites differ systematically from realized vlatilities, and whether those differences are related to firm risk (beta) size (market cap),growth opportunities (market/book), and momentum. Here's the abstract:

Using a complete sample of US equity options, we analyze patterns of implied volatility in the cross-section of equity options with respect to stock characteristics. We find that high-beta stocks, small stocks, stocks with a low-market-to-book ratio, and non-momentum stocks trade at higher implied volatilities after controlling for historical volatility. We find evidence that implied volatility overestimates realized volatility for low-beta stocks, small caps, low-market-to-book stocks, and stocks with no momentum and vice versa. However, we cannot reject the null hypothesis that implied volatility is an unbiased predictor of realized volatility in the cross section.

Read the whole thing here.

HT: CXO Advisory Group

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