Risk-Neutral Skewness, Informed Trading, and the Cross Section of Stock Returns

Abstract

In this article, we use volatility surface data from options contracts to document a strong, robust, and positive cross-sectional relation between risk-neutral skewness (RNS) and subsequent stock returns. The differential return between high- and low-RNS stocks amounts to 0.17% per week. Preannouncement RNS is positively related to earnings announcement returns, and the positive RNS–return relation is more pronounced for other nonscheduled news releases. This suggests that it is informed trading that drives the positive relation between RNS and subsequent stock returns. We also find that RNS contains incremental information beyond trading signals captured by option-implied volatility and volume.

Information and the arrival rate of option trading volume

“…These differences are significant at 1% level except for put options. In general, our measures capture private information before earnings announcements, in line with Jin et al (2012) and Chordia, Lin et al (2021). Further, Roll et al (2010) and Johnson and So (2012) suggest that option trading rather than trade direction reflects more information in the options market, therefore we expect that will be insignificant as it is a directional intensity measure.…”

The Skewness Risk in the Energy Market

“…The most common approach is to write the pricing kernel as linear in the underlying sources of risk. In this context with quadratic terms, the pricing kernel is written as below following Jondeau et al (2019): The difficulty in measuring skewness is still present to date; for example, Neuberger (2012) and Jiang et al (2020), who propose a different measure of computing the skewness factor due to the inconclusive predictive power of skewness that is measured in a standard way; Stilger et al (2016) and Chordia et al (2020), who find positive predictive power on the skewness factor and Albuquerque (2012), who reconciles evidence of skewness of return on firm versus aggregate returns. The result observed in this study, together with the current state of the literature, confirms that an accurate measure of skewness of returns is needed to strengthen this area of research.…”

Option‐implied moments and the cross‐section of stock returns

“…In this second stream of research, the standard approach used is to calculate a single measure from option prices and then to examine the return predictability of this measure. For example, this measure could be the implied volatility (see Guo & Qiu, 2014), the steepness of the implied volatility smirk (see Xing et al, 2010), the volatility asymmetry (see Huang & Li, 2019), the convexity of the implied volatility curve (see Park et al, 2019), or the implied SKEW (see Chordia et al, 2020; Conrad et al, 2013; Stilger et al, 2017, inter alia). Since however option prices observed across moneyness contain information for the probability density function of future stock returns, the use of a single measure measuring one particular property of this density may ignore valuable information for the return predictability of option prices.…”