Why do option prices predict stock returns
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Why Do Option Prices Predict Stock Returns?. Joost Driessen , Tilburg University Tse-Chun Lin, University of Hong Kong Xiaolong Lu, University of Hong Kong. NTU Seminar 2012. Main Questions. Do informed traders reveal their private information in options market?

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Why Do Option Prices Predict Stock Returns?

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Why do option prices predict stock returns

Why Do Option Prices Predict Stock Returns?

JoostDriessen, Tilburg University

Tse-Chun Lin, University of Hong Kong

Xiaolong Lu, University of Hong Kong

NTU Seminar 2012


Main questions

Main Questions

Do informed traders reveal their private information in options market?

Specifically, does their trading activities contain information about future corporate news and stock returns?

Information Content/Driessen, Lin & Lu


Empirically we ask

Empirically, We Ask

Can option trading proxies (IV spread and skew) predict earnings-related or analyst-related news?

Can they predict future stock returns and how?

Essentially, to what extent does the stock return predictability come from days with earnings-related or analyst-related corporate events?

Information Content/Driessen, Lin & Lu


Intuitions and related literature

Intuitions and related literature

Informed traders choose options market for high leverage or equity short-sale constraints (Black (1975), Back (1993), Easley, O’Hara, and Srinivas (1998)).

Proxies for option trading can predict future stock returns (Cremers and Weinbaum (2010), Xing, Zhang, and Zhao (2010)).

Information Content/Driessen, Lin & Lu


Major findings

Major Findings

IV spread and IV skew predict the magnitude of earnings surprises, analyst recommendation changes, and analyst forecast revisions.

IV spread and IV skew predict next week excess stock returns.

12.2% (12.4%) of the stock return predictability of the IV spread (IV skew) comes from our three main events, which account 5.3% (6.6%) trading days.

Information Content/Driessen, Lin & Lu


Why do option prices predict stock returns

Data

Sample period: 1999 to 2010

Option data: OptionMetrics

Event data: Institutional Brokers' Estimate System (I/B/E/S), First Call Historical Database (FCHD)

Stock data: Center for Research in Security Prices (CRSP)

Accounting data: Compustat

Information Content/Driessen, Lin & Lu


Two option trading proxies

Two Option Trading Proxies

Implied volatility (IV) spread: Cremers and Weinbaum (2010)

Implied volatility (IV) skew: Xing, Zhang, and Zhao (2010)

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Five corporate event measures

Five Corporate Event Measures

Following (Boehmer, Jones, and Zhang (2010)), we focus on

Earnings announcement: measured by standardized unexpected earnings (SUE)

Managerial Guidance: forecast issued by the company less the corresponding analyst consensus

Earnings restatement: newly stated quarterly EPS less the previous one

Analyst recommendation change: number of notches changed

Analyst forecast revision: new analyst consensus less the old one

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Descriptive statistics of iv proxies

Descriptive Statistics of IV Proxies

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Descriptive statistics of iv proxies1

Descriptive Statistics of IV Proxies

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Descriptive statistics of corporate events

Descriptive Statistics of Corporate Events

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H1 option trading proxies and upcoming events

H1: Option Trading Proxies and Upcoming Events

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H1 option trading proxies and upcoming events1

H1: Option Trading Proxies and Upcoming Events

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H2 decomposition of stock return predictability by option trading proxies

H2: Decomposition of Stock Return Predictability by Option Trading Proxies

Standard errors are double clustered at firm and quarter level

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H2 1 stock return predictability by option trading proxies

H2.1: Stock Return Predictability by Option Trading Proxies

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Portfolio sorting based on IV proxies


H2 decomposition of stock return predictability by option trading proxies1

H2: Decomposition of Stock Return Predictability by Option Trading Proxies

Information Content/Driessen, Lin & Lu


H2 decomposition of stock return predictability by option trading proxies2

H2: Decomposition of Stock Return Predictability by Option Trading Proxies

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H2 decomposition of stock return predictability by option trading proxies3

H2: Decomposition of Stock Return Predictability by Option Trading Proxies

Information Content/Driessen, Lin & Lu

IV spread:

-event days /sample period =

- overall predictability:

- predictability related to events:

IV skew:

- event days /sample period =

- overall predictability:

- predictability related to events:


H2 decomposition of stock return predictability by option trading proxies4

H2: Decomposition of Stock Return Predictability by Option Trading Proxies

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IV spread:

- predictability related to earnings announcement :

- predictability related to recommendation change :

- predictability related to forecast revision:

IV skew:

- predictability related to recommendation change :


H2 decomposition of stock return predictability by option trading proxies5

H2: Decomposition of Stock Return Predictability by Option Trading Proxies

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Fama-French three-factor analysis on long-short portfolio


Why do option prices predict stock returns

Additional Test I

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Short-sale constraints or leverage?

Piece-wise regressions with the median of the IV proxy as the kink point


Why do option prices predict stock returns

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Additional test ii

Additional Test II

Role of option market liquidity

where is the average option bid-ask spread over

the previous week, measuring the option market illiquidity

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Why do option prices predict stock returns

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Why do option prices predict stock returns

Additional Test III

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IV proxies in post-event periods


Why do option prices predict stock returns

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Why do option prices predict stock returns

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Robustness check i

Robustness Check I

Changes in IV proxies:

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Why do option prices predict stock returns

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Robustness check ii

Robustness Check II

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One month prediction:

- Only the information story or more?


Why do option prices predict stock returns

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Other robustness checks

Other Robustness Checks

Similar results when measuring the skew as OTM put – ATM put

Similar results using the various alternative measures for volatility spreads

The right skew does not do much, this is consistent with that using negative information is more important in the option market

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Conclusion

Conclusion

Information Content/Driessen, Lin & Lu

IV skew and IV spread can predict the earnings announcements, the analyst recommendation changes and the analyst forecast revisions.

12.2% (12.4%) of the return predictive power of IV spread (IV skew) comes from private information of the three main events,which account 5.3% (6.6%) trading days.

Short-sale constraint plays a more important role than the leverage when informed investors choose the option market.

The results are less pronounced when the option market is more illiquid.

Option traders quickly reduce their positions during the post-event weeks.


Thank you tse chun lin tsechunlin@hku hk

Thank You Tse-Chun [email protected]

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