Abstract
We establish a direct link between sophisticated investors in the option market, private stock market investors, and the idiosyncratic volatility (IVol) puzzle. To do so, we employ three option-based volatility spreads and attention data from Google Trends. In line with the IVol puzzle, the volatility spreads indicate that sophisticated investors indeed consider high-IVol stocks as being overvalued. Moreover, the option measures help to distinguish overpriced from fairly priced high-IVol stocks. Thus, these measures are able to predict the IVol puzzle’s magnitude in the cross-section of stock returns. Further, we link the origin of the IVol puzzle to the trading activity of irrational private investors as the return predictability only exists among stocks that receive a high level of private investor attention. Overall, our joint examination of option and stock markets sheds light on the behavior of different investor groups and their contribution to the IVol puzzle. Thereby, our analyses support the intuitive idea that noise trading leads to mispricing, which is identified by sophisticated investors and exploited in the option market.
Highlights
Investor groups differ with respect to their behavior in financial markets
We find support for the theoretical prediction relying on option-based measures of informed trading, which indicate that sophisticated investors trade against overvalued high-idiosyncratic volatility (IVol) stocks in the option markets
In high investor attention periods, on the contrary, we observe a very pronounced IVol puzzle among the stocks with negative sophisticated trader opinion. These results strongly support the following intuitive line of argument for the IVol puzzle: irrational noise trading can lead to an overvaluation of high-IVol stocks, which is identified by sophisticated investors and exploited in the option market
Summary
Investor groups differ with respect to their behavior in financial markets. In particular, sophisticated and private investors deviate with respect to their relation to stock mispricing. In high investor attention periods, on the contrary, we observe a very pronounced IVol puzzle among the stocks with negative sophisticated trader opinion These results strongly support the following intuitive line of argument for the IVol puzzle: irrational noise trading can lead to an overvaluation of high-IVol stocks, which is identified by sophisticated investors and exploited in the option market. To further support these behavioral arguments, we refer to previous empirical evidence and investigate the role of illiquidity and short-sell constraints. Activity in the option market (Jarrow et al 2018), which justifies the use of option data to elicit sophisticated investors’ opinions. 3 While Google Trends directly measures search activity for a specific company, other attention measures such as a firm’s press coverage represent only indirect attention proxies that assume a positive relation between information demand and information supply
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