Using Option Implied Volatilities to Predict Absolute Stock Returns - Evidence from Earnings Announcements and Annual Shareholderss Meetings

The effect of option transaction costs on informed trading in the options market around earnings announcements

“…To predict the realized volatility in the earnings announcement window [0, +2], we calculate the implied earnings announcement volatility (IVOL) using the implied volatility of two ATM call options assuming that the ex‐ante stock return volatility is constant over time except for the earnings announcement days ([0, +2]) on which volatility is higher (Barth & So, 2014; Daley, Senkow, & Vigeland, 1988; Dubinsky et al., 2019; Govindaraj et al., 2015; Patell & Wolfson, 1979, 1981). The details about the construction of this measure are discussed in Appendix B.…”

“…Prior research suggests that the implied volatility of ATM options are predictive of future stock return volatility in the period before the option expires (e.g., Billings & Jennings, 2011; Canina & Figlewski, 1993; Christensen & Prabhala, 1998; Harvey & Whaley, 1992; Jorion, 1995; Roll et al., 2010). Following Barth and So (2014), Govindaraj, Jin, Livnat, and Zhao (2015) and Dubinsky, Johannes, Kaeck, and Seeger (2019), we calculate the implied earnings announcement volatility using two ATM call options. The implied earnings announcement volatility reflects the option market's expectation about stock market volatility in the earnings announcements window [0, +2].…”

Option‐implied information and stock herding

“…4 We consider index implied volatility as an indicator of market stress, given that given that implied volatility is often considered as a proxy for investor sentiment regarding the future state of the market. Furthermore, the forecasting ability of implied volatility over future stock returns (Govindaraj, Jin, Livnat, & Zhao, 2014;Lin & Lu, 2015) highlights a strong relationship between implied volatility and the way in which investors form expectations about the future which could, in turn, affect their decision on whether to follow the market consensus when trading stocks. We follow the Britten-Jones and Neuberger (2000) methodology to construct model-free estimates of future market volatility using options written on the S&P 500 index.…”

“…Options, in particular, have been shown to contain information about the future distribution of stock returns that is incremental to information that is contemporaneously available in the underlying equity market. For instance, previous studies have shown that stock returns can, to some extent, be forecasted using option-implied volatility (Govindaraj, Jin, Livnat, & Zhao, 2014;Lin & Lu, 2015), option-implied skewness (Conrad, Dittmar, & Ghysels, 2013;Fu, Arisoy, Shackleton, & Umutlu, 2016;Jin, Livnat, & Zhang, 2012;Liu, Pong, Shackleton, & Zhang, 2014), and measures related to options trading volume (Blau & Wade, 2013;Pan & Poteshman, 2006;Roll, Schwartz, & Subrahmanyam, 2010). In this spirit, our emphasis throughout this paper is to understand if measures extracted from the options market (which could reflect investors' expectations about future stock returns) can explain why investors might choose to follow the consensus during certain periods, even if they do not necessarily herd as a general strategy.…”

What do we know about individual equity options?

“…Later studies show that individual equity options’ forecasting regarding stock prices and returns can also be derived from higher moments of the risk‐neutral distribution. For instance, Govindaraj et al () and Lin and Lu () find that the volatility of the risk‐neutral distribution has significant forecasting power for future stock returns, especially during important firm‐specific events. However, Bali and Hovakimian () show that sorting stocks into portfolios based on the volatility of their risk‐neutral distribution results in statistically insignificant stock returns; they suggest that it is the call–put risk‐neutral volatility spread that is actually predicting future stock returns.…”