Why do options prices predict stock returns?

We use a new approach to assess the information transmission between options and stock markets. We study whether the predictive power of option-implied volatilities (IVs) on stock returns lies in analyst-related and/or earnings-related news. We find that two proxies foroptions trading (IV skew and IV spread) predict analyst recommendation changes, analyst forecast revisions, and earnings surprises. Next, we show that the IV skew and IV spread predict stock returns, and that the degree of predictability more than doubles around analyst-related and earnings-related events. Additionally, we find that informed traders choose to use the options market particularly because of short-sale constraints on the underlyingstock. We also find that the informed options trading increases with the options market liquidity.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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