A smiling bear in the equity options market and the cross‐section of stock returns

Abstract

We propose a measure for the convexity of an option-implied volatility curve, IV convexity, as a forward-looking measure of risk-neutral tail-risk contribution to the perceived variance of underlying equity returns. Using equity options data for individual US-listed stocks during 2000-2013, we find that the average realized return differential between the lowest and highest IV convexity quintile portfolios exceeds 1% per month, which is both economically and statistically significant on a risk-adjusted basis. Our empirical findings indicate the contribution of informed options trading to price discovery in terms of the realization of tail-risk aversion in the stock market.

Informed options trading on the implied volatility surface: A cross‐sectional approach

“…This result indicates that both short-term implied volatility convexity, Convexity m 1 , and long-term implied volatility convexity, Convexity m 6 , have the ability to forecast future equity returns. This is consistent with the findings of Park et al (2019) that the average return differential between the lowest and highest convexity quintile portfolios exceeds 1% per month, which is both economically and statistically significant on a risk-adjusted basis.…”

“…carries extra predictive power for future stock returns, controlling for the return predictability of Spread m 1 (Smirk m 1 , Convexity m 1 ) of stock return distribution. This is in line with identified by Park et al (2019), Xing et al (2010), and Yan (2011).…”

“…Numerous empirical studies have identified the one-way information transmission from the options market to the stock market, as the options market is recognized by informed investors as an ideal venue for opportunities to capitalize on their informational advantage (see, for example, Park et al, 2019;Xing et al, 2010). They report that the cross-sectional return predictability of IV smirk and IV convexity disappears as the forecasting horizon increases to several months.…”

“…To calculate these measures, we choose options with 6-month time-to-maturity as a benchmark of long-term options and options with 1-month time-to-maturity as a benchmark of short-term options. We then calculate variables related to daily long-and short-term option-implied volatility curves following Park et al (2019), Xing et al (2010), and Yan (2011). These variables are defined as follows:…”

“…We next examine the relationship between the convexity of an option-implied volatility curve, Convexity, and future stock returns. As Park et al (2019) suggest, Convexity is a forward-looking measure of excess tail-risk contribution to the perceived variance of underlying equity returns. Panel C in Table 3 reports the average number of firms; the means and standard deviations of the Convexity m 6 , Convexity m 1 , and Ortho Convexity m m 6 ,1 for each quintile portfolio; and the average portfolio monthly returns.…”