Implied Volatility Spread Research Articles

Quality issues of implied volatilities of index and stock options in the OptionMetrics IvyDB database

AbstractFor stock and index options in the United States, OptionMetrics records prices at 3:59 p.m., not 4:00 p.m. as assumed in previous literature. The resulting 1‐min time discrepancy with closing share prices creates artificial variability in implied volatility spreads and strongly affects market‐wide spreads. It leads to particularly large distortions at the onset of the COVID‐19 pandemic. For index options in Europe, OptionMetrics data show large deviations from put‐call parity even though the original option prices match the parity exactly. Finally, the implied volatilities of stock options in Europe show clusters of exceptional deviations due to incorrect dividend information.

Early exercise, implied volatility spread and future stock return: Jumps bind them all

AbstractWe find that early exercise premiums of exchange‐traded single‐stock American puts, in excess of the GBM‐world premium, can negatively predict future stock returns. Simulations suggest that asset‐value jumps, especially the mean jump‐size, can positively drive this excess premium, while jump‐size can also negatively induce the implied volatility (IV) spread of equivalent American option‐pairs. Empirically, controlling for the effect of jump‐size in excess premiums, the premium loses its predictive power. Furthermore, controlling for the excess premium or jump‐size, IV spreads' predictability shown in the literature also diminishes. Our evidence survives under alternative explanations like informed trading, stock mispricing or market frictions.

The Effects of Option Trading Behavior on Option Prices

This paper investigates the relationship between option trading behavior and option pricing patterns. We argue that greater active trading in the options market due to investor overconfidence leads to higher volatility and larger discrepancies in option pricing, which may be captured by implied volatility spread and implied volatility skewness. Using two different measures of excess option trading, we find that trading activities are correlated in different ways with volatility, volatility spread, and volatility skewness. We also find that these relationships exist both over time and cross-sectionally. We suggest that options investors tend to chase “hot” stocks, as we find evidence of a positive relationship between option trading activities and past underlying equity returns. Heavier trading in the options market also tends to make out-of-the-money call options more (less) expensive than the at-the-money counterparts over time (cross-sectionally). Because trading activities do not predict future equity returns, investor overconfidence, and not informed trading, seems to be a more plausible explanation for our findings.

Information flow and credit rating announcements

We employ the implied volatility spread (IVS) and the short lending fee as measures of private information conveyed by their respective markets. Using issuer credit rating announcements as an informational event, we find that both IVS and the short fee have significantly higher predictive power for returns on event days versus non-event days. Both also predict the direction and magnitude of credit rating changes. Consistent with the linkage between the short sale and options markets, in models with both explanatory variables, the short fee remains significant in all specifications, while IVS loses explanatory power.

The Only Constant Is Change: Nonconstant Volatility and Implied Volatility Spreads

AbstractWe examine the predictability of stock returns using implied volatility spreads (VS) from individual (nonindex) options. VS can occur under simple no-arbitrage conditions for American options when volatility is time-varying, suggesting that the VS-return predictability could be an artifact of firms’ sensitivities to aggregate volatility. Examining this empirically, we find that the predictability changes systematically with aggregate volatility and is positively related to the firms’ sensitivities to volatility risk. The alpha generated by VS hedge portfolios can be explained by aggregate volatility risk factors. Our results cannot be explained by firm-specific informed trading, transaction costs, or liquidity.

Internet Appendix to the Only Constant is Change: Non-Constant Volatility and Implied Volatility Spreads

Internet Appendix to the Only Constant is Change: Non-Constant Volatility and Implied Volatility Spreads

Information Spillovers Prior to M&A Announcements

In this paper, I study trading activities prior to M&A announcements pertaining to the rivals of the merging firms. I find that not only acquirers and targets experience increases in abnormal trading activities in stock and option markets, but also their rivals. The rise in option trading is especially strong for options that informed traders are most likely to trade. I find that the implied volatility spread (IV spread) constructed from a rival’s option prices the day before the announcement can predict this rival’s cumulative abnormal return (CAR) over the M&A announcement window. As the IV spread is widely adopted as a proxy for informed trading activities in the option market, my findings provide evidence for information spillovers from merging firms to their rivals prior to the announcements of the M&A deals.

Implied Volatility Spread and Stock Mispricing

Stocks can be mispriced for at least two reasons: value-relevant information is not timely incorporated or investor sentiment can induce mispricing. Using the mispricing measure proposed by Stambaugh, Yu, and Yuan (2015), we show that informed trading in the options market, proxied by the implied volatility spread, can substantially alleviate stock mispricing. Higher implied volatility spread reliably predicts subsequently lower stock mispricing after controlling for an array of economic variables including firm size, illiquidity, idiosyncratic volatility, institutional ownership, and investor’s divergence of opinions. In addition, this effect is more pronounced when the options trading volume is higher, consistent with the notion that higher options trading volume provides better camouflage for informed trading in the spirit of Kyle (1985). Our findings highlight the importance of information incorporation to reduce asset mispricing. We further show that a self-financing monthly portfolio that goes long on most underpriced stocks and short on most overpriced stocks when the implied volatility spread is the lowest yields statistically and economically significant abnormal returns.

Informed options trading prior to FDA announcements

AbstractWe find that pre‐announcement implied volatility spreads and options trading activity are abnormally elevated and can predict Food and Drug Administration (FDA) announcement date stock returns. The effect is more pronounced in firms with higher levels of information asymmetry and lower‐quality corporate governance suggesting that some options traders are informed in advance of the details that affect the stock price impact of the FDA news. We provide the first examination of informed options trading prior to FDA announcements during a 21‐year period. Our findings have implications for regulators, investors and relevant firms.

Variation in option implied volatility spread and future stock returns

A consistent theme in the finance literature is that implied volatility measures have predictive power for future stock returns and thus reflect investor beliefs about future stock valuations. We use the variability of option implied volatility spread as a proxy for the impounding of new information, and changes in the interpretation of existing information, into option prices. Over the 2006–2016 period, we find that the predictive power of option implied volatility spread for future stock returns is significantly greater when implied volatility spread has been more variable in the past. Our results are statistically and economically significant and robust in both univariate and multivariate settings. Overall, our findings suggest a portfolio strategy using the conjunction of both the level and variability of the implied volatility spread results in significantly better portfolio performance than using the level alone.

Can the Implied Information of Options Predict the Liquidity of Stock Market? A Data-Driven Research Based on SSE 50ETF Options

Liquidity reflects the quality of the market. When the market is short of liquidity, it often causes investors’ trading difficulties and stock price volatility, expanding the investment risk. As a risk management tool, options attract more informed investors to trade because of their flexible design. To explore whether the implied information based on the formation of option price can predict the liquidity of stock market, we take SSE 50ETF options from February 9, 2015, to December 31, 2020, as the research sample. Based on the idea of data-driven approach, we extract the implied information contained in option price, including implied volatility, implied volatility spread, and variance risk premium. Through the regression analysis method, we examine the ability to predict the liquidity of the stock market. The results show that implied volatility spread has the strongest ability to predict the liquidity of the stock market, and it is more significant within 270 days. Implied volatility contains the information about the short-term (120 days) liquidity of the stock market in the future. It shows that implied volatility and implied volatility spread are good indicators to predict stock market liquidity. In contrast, variance risk premium cannot predict the liquidity of stock market. The research conclusion verifies the role of option-implied information in predicting the stock market’s liquidity. By extracting the information of options price, investors and financial regulators can scientifically participate in the financial market under data guidance.

Investor sentiment, misreaction, and the skewness‐return relationship

AbstractThis study examines the effect of investor sentiment on misreaction and explores the time‐series relationship between risk‐neutral skewness (RNS) and subsequent stock market returns contingent on sentiment‐induced overreaction. Using the adjusted put‐call implied volatility spread as a misreaction proxy and Bakshi et al.'s method to measure RNS, we find that pessimism leads to overreaction. This overreaction could strengthen the negative RNS‐return relationship, with higher market returns following lower RNS. Our results are robust even after excluding the sample period of the 2008 financial crisis, profiting from market‐timing strategies based on the levels of RNS and overreaction, and using an alternative RNS measure.

The Performance of Trading Strategies Based on Deviations from Put-Call Parity of Stock Options

According to Cremers and Weinbaum [6], we compute the implied volatility spread by option put-call parity theory. Then, we build strategy based on implied volatility spread and compares it with OS, 52-week high, and contrarian investment strategies to explore whether the investment performance of the implied-volatility-spread based strategy is better than other strategies. Moreover, we combine the implied-volatility-spread based strategy with other strategies to form the two-dimensional investment strategy to explore whether the performance of two-dimensional implied-volatility-spread strategy is better than one-dimensional implied-volatility-spread strategy. The empirical results show that it needs more than one year of investment horizon to get positive abnormal return by implied-volatility-spread based strategy. Otherwise, it will only receive negative abnormal return when the investment horizon is less than one year. In addition, two-dimensional strategy improves bad performance of one-dimensional strategy. After combining the contrarian 52-week high and contrarian investment strategy with implied-volatility-spread strategy, we find that there is the best strategic effect when the holding period is 12 months. Nevertheless, the abnormal returns decrease after the holding period is 24 months. JEL classification numbers: G11, G12. Keywords: Implied-volatility-spread, OS strategy, 52-week highs strategy, Trading volume strategy, Price momentum strategy, Option volume.

Information Content of Aggregate Implied Volatility Spread

Aggregate implied volatility spread (IVS), defined as the cross-sectional average difference in the implied volatilities of at-the-money call and put equity options, is significantly and positively related to future stock market returns at daily, weekly, and monthly to semiannual horizons. This return predictive power is incremental to existing return predictors, and it is significant both in sample and out of sample. Furthermore, IVS can forecast macroeconomic news up to one year ahead. The return predictability concentrates around macro news announcement. Common informed trading in equity options offers an integrated explanation for the ability of IVS to predict both future stock market returns and real economic activity.This paper was accepted by Tyler Shumway, finance.

Options-implied information and the momentum cycle

We employ options-implied information derived from implied volatility spreads and implied volatility skews to identify the momentum stage of stocks. We show that the early-stage (late-stage) momentum strategy of buying identified early-stage (late-stage) winners and selling identified early-stage (late-stage) losers outperforms (underperforms) the conventional momentum strategy of buying winners and selling losers across all momentum stages. We also find that the price momentum of the early-stage (late-stage) momentum strategy experiences slower (faster) reversal than that of the conventional momentum strategy. The outperformance of the early-stage momentum strategy comes primarily from the contribution of losers, as options-implied measures better place losers in their momentum stages than winners. Moreover, the identification ability of options-implied measures increases with the informativeness of the options market and, more importantly, is driven by their predictive information about a firm’s fundamentals, particularly for profitability. Overall, our results indicate that options-implied information is useful in identifying the momentum stages of stocks.

Information Content of Options Trading Prior to Dividend Initiations

This article utilizes options markets to determine the information content of dividend initiation announcements. Pre-event informed options trading, measured by abnormal implied volatility spread and skew, predicts the cumulative abnormal returns around dividend initiation announcements. Options trading is more informative on dividend initiation announcement returns when the options market is more liquid, the underlying stock market is less informed, and the dividend initiations are of a greater surprise to the market. The results are robust to a randomization test and support the conclusion that pre-event options trading contains information about the market reaction to dividend initiation announcements. TOPICS:Derivatives, options, legal/regulatory/public policy, information providers/credit ratings Key Findings • The information content of options trading is stronger when the options market is more liquid relative to the underlying stock market. • The information content of options trading is higher when the dividend initiating firms have relatively lower pre-initiation cash flows. • The predictive power of informed options trading is weaker when the underlying stock market is subject to more informed trading.

The effects of an increase in equity tick size on stock and option transaction costs

Abstract We examine the impact of the 2016 U.S. SEC Tick Size Pilot Program on transaction costs in both the equity and options markets. We find that an increase in the tick size from one-cent to five-cents increases percent bid-ask spreads for test stocks vis-a-vis control stocks; however, this increase is substantially reduced when the test stocks have actively traded options. We also find a spillover effect in transaction costs from the underlying stock market to the options market, as both percent bid-ask spreads and implied volatility spreads widen in options for test stocks versus control stocks. Lastly, we find reversal effects at the conclusion of the pilot program, as percent spreads in both the equity and options markets narrow when the tick size is reduced.

Information Leakage in Energy Derivatives around News Announcements

We examine the behavior of US crude oil and natural gas futures options implied volatility based measures as proxies for information leakage around news announcements between 2007 and 2017. In the five days preceding news releases, we report abnormal changes in the levels of futures options implied volatility spreads and skew. In addition, we report a statistically significant relationship between abnormal announcement date returns and abnormal changes in pre-announcement implied volatility spreads/skew. Our findings indicate that at least some investors are informed about the details of future crude oil and natural gas news. TOPICS:Options, derivatives Key Findings • The study offers a unique examination of information leakage in crude oil and natural gas futures options prior to commodity specific news between 2007 to 2017. • We report abnormal changes in implied volatility spreads and skew in the five days prior to news announcements. • Pre-announcement abnormal options trading activity indicates that some traders have knowledge about the details of upcoming energy news.

Informed Options Trading Around U.S. FDA Announcements

We provide the first examination of informed options trading around US Food and Drug Administration announcements between 1996 and 2016. Using implied volatility spreads and options trading volume, we find that informed traders are aware of the timing of the news at least five days in advance, and at least some informed traders have knowledge of the details which affect the price impact of the announcement. Such findings are more prevalent in firms with higher levels of information asymmetry and lower quality corporate governance, suggesting insider trading as a possible source of the abnormal options trading activity. Our findings have implications for regulators, investors, and relevant firms.

Predicting the equity premium with the implied volatility spread

We show that the call-put implied volatility spread (IVS) outperforms many well-known predictors of the U.S. equity premium at return horizons up to six months over the period from 1996:1 to 2017:12. The predictive ability of the IVS is unrelated to the dividend yield and is useful in explaining the cross-section of returns. Decomposing the IVS, we find the longer run predictive ability of the IVS operates primarily through a cash flow channel. We also find the IVS is significantly related to indicators of aggregate market direction and expected market conditions. Our results are consistent with the IVS reflecting market sentiment as well as information about informed trading.