Last Updated on 10 February, 2024 by Rejaul Karim
The study “What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?” by Xiaoyan Zhang, Rui Zhao, and Yuhang Xing, explores the predictive capabilities of the volatility smirk in option trading.
The research finds that the degree of volatility smirk is indicative of future equity returns. Specifically, stocks with steeper smirks in their traded options tend to underperform compared to those with less marked volatility smirks—potentially grappling with a gap of around 10.9% annually.
This trend extends for at least six months, further linking steeper volatility smirks to more significant future earnings shocks. The findings illuminate the strategies of informed traders and stock market responses to the predictive information latent in volatility smirks.
Abstract Of Paper
The shape of the volatility smirk has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 10.9% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with the steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to trade out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.
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Tsinghua University – PBC School of Finance
The paper “What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?” articulates the predictive significance of the volatility smirk’s shape for future equity returns.
Findings unveil that stocks demonstrating the steepest smirks in traded options underperform others by approximately 10.9% annually, adjusting for risk, a dynamic that can persist for a minimum of six months. Moreover, companies with the sharpest volatility smirks tend to face the most challenging earnings shocks in the subsequent quarter.
These results align with the notion that informed traders expecting negative news are inclined to trade out-of-the-money put options, and that the equity market exhibits a delay in absorbing the information encapsulated in volatility smirks.
This study thus underscores the value infused in understanding the nuanced cues offered by volatility smirks in making more informed investment decisions.
How does the research paper characterize the relationship between the volatility smirk and future equity returns?
The research paper finds a significant cross-sectional predictive relationship between the shape of the volatility smirk in options trading and future equity returns. Stocks with steeper smirks in their traded options are shown to underperform those with less pronounced volatility smirks. This predictive power persists for at least six months, indicating that the volatility smirk contains valuable information about future stock performance.
What is the magnitude of the underperformance associated with steeper volatility smirks, and is this risk-adjusted?
Stocks with the steepest smirks in their traded options underperform by approximately 10.9% annually, and this underperformance is risk-adjusted. The risk-adjusted measure accounts for the level of risk associated with the observed underperformance, making it a more reliable indicator of the impact of volatility smirks on future equity returns.
How do the findings connect steeper volatility smirks to future earnings shocks, and what does this suggest about market responses?
The research shows that companies with the steepest volatility smirks are more likely to experience significant negative earnings shocks in the following quarter. This connection suggests that the shape of the volatility smirk may be indicative of underlying financial conditions or expectations. The delayed market response to this information implies that the equity market is slow in fully incorporating the insights embedded in volatility smirks, providing opportunities for informed traders.