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

Abstract

AbstractWe 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.