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Why Do Option Prices Predict Stock Returns?

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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  1. 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

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. Two Option Trading Proxies Implied volatility (IV) spread: Cremers and Weinbaum (2010) Implied volatility (IV) skew: Xing, Zhang, and Zhao (2010) Information Content/Driessen, Lin & Lu

  8. 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 Information Content/Driessen, Lin & Lu

  9. Descriptive Statistics of IV Proxies Information Content/Driessen, Lin & Lu

  10. Descriptive Statistics of IV Proxies Information Content/Driessen, Lin & Lu

  11. Descriptive Statistics of Corporate Events Information Content/Driessen, Lin & Lu

  12. H1: Option Trading Proxies and Upcoming Events Information Content/Driessen, Lin & Lu

  13. H1: Option Trading Proxies and Upcoming Events Information Content/Driessen, Lin & Lu

  14. H2: Decomposition of Stock Return Predictability by Option Trading Proxies Standard errors are double clustered at firm and quarter level Information Content/Driessen, Lin & Lu

  15. H2.1: Stock Return Predictability by Option Trading Proxies Information Content/Driessen, Lin & Lu Portfolio sorting based on IV proxies

  16. H2: Decomposition of Stock Return Predictability by Option Trading Proxies Information Content/Driessen, Lin & Lu

  17. H2: Decomposition of Stock Return Predictability by Option Trading Proxies Information Content/Driessen, Lin & Lu

  18. 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:

  19. H2: Decomposition of Stock Return Predictability by Option Trading Proxies Information Content/Driessen, Lin & Lu IV spread: - predictability related to earnings announcement : - predictability related to recommendation change : - predictability related to forecast revision: IV skew: - predictability related to recommendation change :

  20. H2: Decomposition of Stock Return Predictability by Option Trading Proxies Information Content/Driessen, Lin & Lu Fama-French three-factor analysis on long-short portfolio

  21. Additional Test I Information Content/Driessen, Lin & Lu Short-sale constraints or leverage? Piece-wise regressions with the median of the IV proxy as the kink point

  22. Information Content/Driessen, Lin & Lu

  23. 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 Information Content/Driessen, Lin & Lu

  24. Information Content/Driessen, Lin & Lu

  25. Additional Test III Information Content/Driessen, Lin & Lu IV proxies in post-event periods

  26. Information Content/Driessen, Lin & Lu

  27. Information Content/Driessen, Lin & Lu

  28. Robustness Check I Changes in IV proxies: Information Content/Driessen, Lin & Lu

  29. Information Content/Driessen, Lin & Lu

  30. Robustness Check II Information Content/Driessen, Lin & Lu One month prediction: - Only the information story or more?

  31. Information Content/Driessen, Lin & Lu

  32. 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 Information Content/Driessen, Lin & Lu

  33. 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.

  34. Thank You Tse-Chun Lin林則君tsechunlin@hku.hk Information Content/Driessen, Lin & Lu

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