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What Does the Individual Option Volatility Smirk Tell Us About Future Equity Returns?

Published online by Cambridge University Press:  31 March 2010

Yuhang Xing ,
Xiaoyan Zhang  and
Rui Zhao
Yuhang Xing
Affiliation:
Jones School of Management, Rice University, 6100 Main St., Houston, TX 77005. yxing@rice.edu
Xiaoyan Zhang
Affiliation:
336 Sage Hall, Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853. xz69@cornell.edu
Rui Zhao
Affiliation:
Blackrock Inc., 40 E. 52nd St., New York, NY 10022. rui.zhao@blackrock.com
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Abstract

The shape of the volatility smirk has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by 10.9% per year on a risk-adjusted basis. This predictability persists for at least 6 months, and firms with the steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to trade out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 3 , June 2010 , pp. 641 - 662
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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