Variation in option implied volatility spread and future stock returns

• Published in: The Quarterly review of economics and finance 2022-02, Vol.83, p.152-160
• Main Authors: DeLisle, R. Jared, Diavatopoulos, Dean, Fodor, Andy, Kassa, Haimanot
• Format: Article
• Language: English
• Subjects: Implied volatility spread; Information; Options; Stock returns
• ISSN: 1062-9769; 1878-4259
• DOI: 10.1016/j.qref.2021.12.004

•Literature shows call-put implied volatility spread (CPIV) robustly predicts stock returns.•Variability of CPIV is informative beyond its level.•The predictive power of CPIV is greater when historical CPIV is more volatile.•A strategy using both CPIV level and variability dramatically improves portfolio 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.