Abstract
This study examines whether out-of-the-money (OTM) option prices, which determine the Risk-Neutral Skewness (RNS) of the underlying stock return distribution, contain information with respect to subsequent stock outperformance. A long-only portfolio containing the stocks with the highest values of RNS, or the biggest increases in RNS (ΔRNS) relative to the previous trading day, yields significant risk-adjusted performance in the post-ranking week during the period 1996-2014. This outperformance is mainly driven by stocks that are relatively underpriced and are exposed to greater downside risk. These findings are consistent with a trading mechanism, according to which investors may choose to exploit perceived stock underpricing by buying (selling) OTM call (put) options due to their embedded leverage, rather than directly buying the underlying stock, to avoid exposure to its potential downside risk. In this case, the option market leads the stock market with respect to positive price discovery, but due to the absence of severe limits-to-arbitrage for the long-side, the price correction signalled by RNS is very quick, typically overnight.
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