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Risk Neutral Skewness Predicts Price Rebounds and so can Improve Momentum Performance Analysis

Last Updated on 10 February, 2024 by Rejaul Karim

The study “Risk Neutral Skewness Predicts Price Rebounds and so can Improve Momentum Performance” by Paul Borochin and Yanhui Zhao presents compelling insights into the predictive power of positive option-implied risk-neutral skewness (RNS) on next-month abnormal underlying stock returns.

The research highlights the association between RNS and upward rebounds of previously undervalued stocks, particularly during post-recession periods when momentum crashes occur. Additionally, the study reveals that the strength of the momentum anomaly is inversely related to the RNS, indicating the potential for improved momentum performance by considering RNS.

The findings are further generalized to non-optionable stocks through the construction of an RNS factor-mimicking portfolio, demonstrating the meaningful superiority of a momentum strategy that avoids performance reversals.

Importantly, these results withstand rigorous controls for trading frictions, firm characteristics, and common risk factors, underscoring the robustness of the observed relationships.

Abstract Of Paper

Positive option-implied risk-neutral skewness (RNS) predicts next-month abnormal underlying stock returns driven by upward rebounds of previously undervalued stocks. The RNS anomaly is strongest in periods of post-recession rebounds when momentum crashes occur. Furthermore, the momentum anomaly is strongest (weakest) in stocks with the most negative (positive) RNS. We generalize our findings to non-optionable stocks by constructing an RNS factor-mimicking portfolio, finding that a momentum strategy that avoids performance reversals has meaningfully superior performance. Our results hold after controlling for trading frictions, firm characteristics, and common risk factors.

Original paper – Download PDF

Here you can download the PDF and original paper of Risk Neutral Skewness Predicts Price Rebounds and so can Improve Momentum Performance.

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Author

Paul Borochin
University of Florida – Department of Finance, Insurance and Real Estate

Yanhui Zhao
University of Wisconsin – Whitewater – College of Business and Economics

Conclusion

The research clearly establishes a critical correlation between positive option-implied risk-neutral skewness (RNS) and subsequent monthly aberrations in stock returns, powered substantially by upswings of formerly undervalued stocks.

Additionally, it’s pertinent that the RNS anomaly amplifies during post-recession rebounds, accompanying momentum crashes. The momentum anomaly exhibits its most potent manifestation in stocks characterized by markedly negative RNS, while those with a significant positive RNS demonstrate the weakest momentum.

By extrapolating these conclusions to non-optionable stocks via an RNS factor-mimicking portfolio, it emerges that tactful avoidance of performance reversals in implementing a momentum strategy yields superior results. It’s noteworthy that these conclusions remain robust, even upon factoring in trading frictions, corporate characteristics, and commonplace risk variables.

Therefore, a positive RNS can indeed foretell price rebounds, thereby intuitively enhancing momentum performance.

Related Reading:

Expected Skewness and Momentum

Investor Sentiment Dynamics, the Cross-Section of Stock Returns and the MAX Effect

FAQ

How does positive option-implied risk-neutral skewness (RNS) impact subsequent stock returns, according to the research?

The study demonstrates that positive option-implied risk-neutral skewness (RNS) is a significant predictor of next-month abnormal underlying stock returns, driven by the upward rebounds of previously undervalued stocks. This finding highlights the predictive power of RNS in anticipating price rebounds.

In what market conditions does the RNS anomaly show its strongest impact, and how does it relate to momentum crashes?

The RNS anomaly is particularly strong during post-recession rebounds when momentum crashes occur. This suggests that RNS is associated with specific market conditions, and its impact is accentuated during periods characterized by rebounding stock prices post-recession.

How does the research suggest improving momentum performance, and what are the key factors considered in this context?

The study suggests that the strength of the momentum anomaly is inversely related to RNS. Stocks with the most negative RNS exhibit the strongest momentum anomaly, while those with significant positive RNS demonstrate the weakest momentum. By avoiding performance reversals in a momentum strategy, particularly when considering RNS, the research indicates the potential for meaningfully superior performance. These conclusions remain robust even after accounting for trading frictions, firm characteristics, and common risk factors.

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