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We study the effect of investor sentiment on the relation between the option to stock volume ratio (O/S) and future stock returns. Relative option volume has return predictability under short sale constraints. For this reason, we expect and find a stronger O/S‐return relation during high sentiment periods than during low sentiment periods. We find that Baker and Wurgler's Investor Sentiment Index affects the O/S‐return relation after controlling for consumer sentiment indices and economic environment factors. While prior studies have used consumer sentiment indices as alternative measures of investor sentiment, our results suggest these effects are distinct.

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This study investigates the impact of uncertainty on the volatility forecasting power of option-implied volatility. Option-implied volatility is a powerful predictor of future volatility, particularly during periods of high uncertainty. This is consistent with option-implied volatility being largely determined by volatility-informed traders (rather than directional traders) when uncertainty is high. New volatility forecasting models that incorporate such interaction outperform benchmark models, both in-and out-of-sample. The new models also better predict future volatility during the 2008 global financial crisis, for which benchmark models perform poorly. The results are robust to alternative choices of benchmark models, loss functions, and estimation windows.