Implied Volatility Spreads and Future Options Returns
Chuang-Chang Chang, Zih-Ying Lin and Yaw-Huei Wang
ABSTRACT While numerous studies have documented that call-put implied volatility spreads positively predict future stock returns, the predictive relationship is recently found to be negative for future call option returns. We further investigate whether and how the predictive relationship for options returns is influenced by various information events and conditions. In addition to confirming the existence of the opposite predictive relationships for both call and put returns, our empirical results reveal that the predictive relationships are stronger during periods of earnings announcement and/or high sentiment. In addition, we find that investors learn from informed trading and revise their predictability bias by examining the impacts of information asymmetry, stock liquidity, and options liquidity on the predictive relationships.
Keywords: Volatility spreads; Option returns; Earnings announcements; Investor sentiment; Investor Learning.
JEL Classification: G14
Chuang-Chang Chang and Zih-Ying Lin are collocated at the Department of Finance, National Central University, Taoyuan, Taiwan, ROC; Yaw-Huei Wang (the corresponding author) is at the Department of Finance, National Taiwan University, Taiwan, ROC. Address for correspondence: Department of Finance, National Taiwan University, No.1 Roosevelt Road, Section 4, Taipei 106, Taiwan, ROC. Tel: 886-2-3366- 1092; email: [email protected]. The authors would like to express their sincere gratitude for the helpful comments provided by Andy Fodor, Yigit Atilgan and Hung-Neng Lai, and would also like to express their appreciation for the financial support provided for this study by the Taiwanese Ministry of Science and Technology (MoST).
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1. INTRODUCTION
Strong support is provided in several prior related studies on the importance of derivatives implied information in the prediction of the price dynamics of the underlying asset, with several of these studies demonstrating that ‘call-put implied volatility’ (CPIV) spreads can positively predict the returns of the underlying stocks.1
These findings are consistent with the argument that based on the advantages of low transaction and high leverage levels, informed traders may initiate the realization of their privileged information in the options markets.2
Moreover, Atilgan (2014) and Chan, Ge, and Lin (2015) found that the predictability of stock returns made by the CPIV is stronger during earnings announcement and merger and acquisition (M&A) announcement events, respectively.
They indicated that the trading activity of informed traders is an important driver of the CPIV, and hence the predictability of stock returns is more pronounced during major information events.
Doran, Fodor and Jiang (2013) recently examined whether the same predictive relationship may exist for options returns, but they found that the CPIV was negatively,
1 Examples include Bali and Hovakimian (2009), Cremers and Weinbaum (2010), Doran and Krieger (2010), and An, Ang, Bali and Cakici (2014). 2 See Manaster and Rendleman (1982), Back (1993), Sheikh and Ronn (1994), Easley, O’Hara and Srinivas (1998), Cao (1999) and Pan and Poteshman (2006). Easley et al. (1998) noted that informed traders with private information are more likely to trade in the options market when option liquidity is high, stock liquidity is low and information asymmetry in the stock market is high, whilst Pan and Poteshman (2006) found that stocks with low put-call ratios outperformed stocks with high put-call ratios, with the predictability of stock returns being higher for those stocks with a higher concentration of informed traders.
2 rather than positively, related to the future returns of call options, particularly for out-of- the-money (OTM) contracts; they suggested that this negative relationship was driven by the options demand from the mispricing attributable to individual investors, a finding which is in line with those of Mahani and Poteshman (2008), Goyal and Saretto (2009) and An et al. (2014).
However, the role of earnings announcement on the predictive relationship for options returns has not yet been explored. Since the option market is a platform where informed traders are likely to realize their private information, the first objective of this paper is to investigate how earnings announcement affects the predictive relationship between the CPIV and future options returns.
Prior studies such as Kandel and Pearson (1995), Amin and Lee (1997), Choy and
Wei (2012), and Choy (2015) have provided evidence of more aggressive trading activity or higher trading volume around earnings announcement. However, whether this change represents useful information for prediction or actually is just a reflection of divergent opinions among traders is still debatable in literature. While one stream claims that earnings announcement is an informationally intensive event (Beaver, 1968;
Ball and Brown, 1968; Battalio and Mendenhall, 2005; Diavatopoulos, Doran, Fodor and Peterso, 2012), the other one argues that trading around earnings announcement is
3 due to differential opinions (Harris and Raviv, 1993; Kim and Verrecchia, 1994).3
We also investigate whether this predictive relationship is found to be stronger during periods of high investor sentiment, essentially because investors are widely regarded as being more irrational, with a tendency to exhibit much more severe misreaction when market sentiment is high; indeed, it has been suggested in a number of behavioral theories that such investors may form incorrect beliefs leading to the erroneous evaluation of assets.4
Several studies have suggested that investor sentiment contains a market-wide component which has a direct effect on the prices of both stocks and options,5 and that investor misreaction is dependent upon investor sentiment.6 As such, investor sentiment may affect the beliefs of investors, thereby increasing the likelihood of such investors exhibiting misreaction during periods of high sentiment, leading to such investors trading more often and more aggressively. Thus, if the predictive relationship in the
3 In particular, Mahani and Poteshman (2008) found that unsophisticated investors in the options market overreacted to past news on the underlying stocks and tended to believe that the stock prices would move away from their fundamental values on the release of earnings announcement news. 4 See, for example, De Long, Shleifer, Summers and Waldmann (1990), Lee, Shleifer and Thaler (1991) and Kumar and Lee (2006). 5 Baker and Wurgler (2006) provided evidence to show that this market-wide sentiment was related to differences in the characteristics of cross-sectional stock returns. Several studies have further shown that sentiment-driven investors lead to prices deviating from their fundamental value in the options markets (see Figlewski, 1989; Figlewski and Green, 1999; Han, 2008; Lemmon and Ni, 2010; and Ofek, Richardson and Whitelaw, 2004). 6 Yu and Yuan (2011) indicated the existence of a positive mean-variance relationship in low-sentiment periods, whilst Chung, Hung and Yeh (2012) noted that the return predictability of sentiment was more pronounced in an expansion state. Stambaugh, Yu and Yuan (2012) found a broad set of anomalies in cross-sectional stock returns, which they found to be stronger following periods of high investor sentiment levels.
4 options market is indeed driven by mispricing, then we would expect to find it becoming stronger during periods of high-sentiment.
We subsequently examine whether investors learns from informed trading and then mitigate their predictability bias in the options markets because prior studies such as Daniel, Hirshleifer, and Subrahmanyam (1998), Gervais and Odean (2001), Nicolosi,
Peng, and Zhu (2009), and Seru, Shumway, and Stoffman (2010) have documented the existence of investor learning in the financial markets. Specifically, we attempt to investigate whether the predictive relationship is found to be weaker during periods of high information asymmetry, low stock liquidity and high options liquidity, essentially because, as suggested by Easley et al. (1998), these are conditions under which informed investors are more likely to trade in options. If the investors learn from informed traders and adjust their trading behavior, then we would expect to find it becoming weaker during periods when informed investors participate more aggressively in the options market.
The empirical findings based on all US listed stocks and options are summarized as follows. Firstly, earnings announcements are found to have significant influences on the predictability of the options returns indicated by the CPIV. The negative
(positive) relationship between CPIV and future call (put) options returns is found to be stronger when it coincides with an earnings announcement event, which is
5 consistent with the findings of Choy and Wei (2012) and Choy (2015). Secondly, we find that an increase in investor sentiment strengthens the negative (positive) relationship between the CPIV and the future returns of call (put) options, which is consistent with the extant behavioral theories in which it is posited that investors may tend to form incorrect beliefs which can lead to them misevaluating their assets during periods of high investor sentiment. Finally, we find that lower stock liquidity, higher options liquidity and higher information asymmetry in the stock market tend to weaken the negative (positive) relationship between the CPIV and the future returns of call
(put) options, which is consistent with the finding of research that investors have learning behavior and hence improve their predictability ability.
Doran et al. (2013) is the study most relevant to this study. However, in addition to confirming the existence of the negative predictive relationship between the CPIV and future returns of call options, we additionally contribute to the literature with the investigation on the following several aspects. Firstly, we examine the effect of earnings announcement on the predictive relationship. Secondly, we show how the predictive relationship changes with investor sentiment. Thirdly, we document whether investors learn from informed trading and then adjust the prediction bias.
The remainder of this paper is organized as follows. Our hypothesis development is described in Section 2, followed in Section 3 by a description of the data used for
6 this study. The empirical methodology adopted for our study is explained in Section 4, with the empirical results subsequently being presented and discussed in Section 5.
Finally, the conclusions drawn from this study are presented in Section 6.
2. HYPOTHESIS DEVELOPMENT
Whether the trading activity around earnings announcement contains useful information or is a result of divergent opinions is still open question. Amin and Lee
(1997) identified a tendency for trading activity within the options market to increase prior to earnings announcements, whereas this was not found to be the case within the market of the underlying stock. As the options market provides a more effective channel for investors to realize their beliefs or privileged information, an interesting question is whether such increase in trading activity is driven by noise traders who believe themselves to be informed, or by actual informed traders.
On the other hand, Choy and Wei (2012) found increased participation by individual investors in the options market around earnings announcement periods, with Choy
(2015) subsequently providing evidence to show behavior biases amongst individual investors in the options market, with such biases being more pronounced prior to earnings announcement periods.7 Consequently, individual investors are likely to play
7 Mahani and Poteshman (2008) also found that unsophisticated option investors tended to overreact to prior news on the stock market and believed that the mispriced stock price would move further away from the fundamental value once the scheduled news was released.
7 an important role in the options market during such earnings announcement periods.
In line with the suggestions of both Manaster and Rendleman (1982) and Sheikh and Ronn (1994) that investors may tend to trade on their information in the options market prior to trading in the market of the underlying stock, Atilgan (2014) found that stocks with higher implied volatility spread (defined as the implied puts minus calls) earned significantly negative stock returns. However, Doran et al. (2013) found that this relationship did not hold in the options market; instead, they documented a negative predictive relationship from the CPIV to call option returns, and therefore posited that the negative relationship was driven by options mispricing by individual investors. In other words, trading by individual investors leads to the mispricing of options, with the options prices subsequently reverting; this is the reason why the CPIV can predict contrary returns for call options.
According to the prior studies cited here, whether and how earnings announcement affects the relationship between the CPIV and future options returns have not reached a consensus. We therefore propose our first hypothesis, as follows:
Hypothesis 1a: The negative (positive) predictability of call (put) option returns
made by the CPIV will be more pronounced around earnings
announcement periods.
Hypothesis 1b: The negative (positive) predictability of call (put) option returns
made by the CPIV will be weaker around earnings announcement
8 periods.
As noted in several of the prior related studies, misreaction is clearly discernible in the options market;8 and indeed, as noted by Chang, Hsieh and Wang (2015), such misreaction tends to be even more severe during periods of high investor sentiment.
Numerous other prior related studies have further suggested that sentiment-driven investors can cause prices to deviate from their fundamental values, with such investor sentiment affecting asset prices in both the stock and options markets.9
Doran et al. (2013) suggested that the negative relationship between CPIV and the future returns of call options is caused by mispricing which is attributable to individual investors. However, investors’ behavior bias is associated with not only their beliefs, but also their sentiment. Mian and Sankaraguruswamy (2012) demonstrate that market-wide investor sentiment affects the sensitivity of stock prices to earnings news, and therefore conclude that the sentiment-driven mispricing of earnings contributes to the general mispricing of stocks due to investor sentiment. We therefore posit that investor sentiment is also an important influence on the relationship between the CPIV and future options returns. In addition, we further examine whether the effect of earnings announcement on the predictive relationship will find to be
8 See Stein (1989), Poteshman (2001), Chao, Li and Yu (2005) and Mahani and Poteshman (2008). 9 The literature on the stock market includes Brown and Cliff (2005), Coval and Shumway (2005), Kumar and Lee (2006), Lemmon and Portniaguina (2006), Baker and Wurgler (2006, 2007), Yu and Yuan (2011) and Stambaugh et al. (2012). See Figlewski (1989), Figlewski and Green (1999), Ofek, Richardson and Whitelaw (2004), Han (2008) and Lemmon and Ni (2010) for an overview of the options market.
9 particularly strong during periods of high investor sentiment. We also expect to find that the sentiment effect will be similarly applicable to put options, which leads on to our second hypothesis, as follows:
Hypothesis 2a: The negative (positive) predictability of call (put) option returns
made by the CPIV will be more pronounced during periods of
high investor sentiment.
Hypothesis 2b: The impact of earnings announcements on the negative (positive)
predictability of call (put) option returns made by the CPIV will
be stronger during periods of high investor sentiment.
Easley et al. (1998) demonstrated that in those cases where stock liquidity is low, options liquidity is high or there is high information asymmetry in the stock market, informed investors are more likely to try to take advantage of their private information within the options market; therefore, there is a greater likelihood of larger numbers of informed investors trading in the options market when any one of these three condition exists. Furthermore, since Doran et al. (2013) suggested that the negative predictability of call option returns made by the CPIV is driven by the mispricing attributable to the demand of individual investors, we posit that this negative relationship will be weakened under any of the three market conditions.
Several studies indicated that trading experience helps improve individual investors’ predictability ability and hence reduce their behavior bias. As Choy and Wei
10 (2012) and Choy (2015) have indicated that greater numbers of individual investors may be found to be trading in the options market during earnings announcement and
Battalio and Mendenhall (2005) and Atilgan (2014) suggested that earnings announcement contains information and informed traders will take advantage of private information prior to the announcement, it will be natural to ask whether individual investors learn and adjust their beliefs from informed trading.
We are, therefore, also interested in determining whether there is any discernible reduction in the effect of earnings announcement on the predictive relationship when information asymmetry in the stock market is high, stock liquidity is low or options liquidity is high. In other words, we conjecture that individual investors learns from informed trading and thus mitigate the mispricing that results in the predictive relationship. We also expect to find that the effects of these information environments are similarly applicable to put options. Accordingly, we propose our third hypothesis, as follows:
Hypothesis 3a: The predictability of call (put) option returns made by the CPIV
will be found to be less negative (positive) when information
asymmetry in the stock market is high, stock liquidity is low or
options liquidity is high.
Hypothesis 3b: The effect of earnings announcement on the predictability of call
(put) option returns made by the CPIV will be found to be less
11 negative (positive) when information asymmetry in the stock
market is high, stock liquidity is low or options liquidity is high.
3. DATA
The primary dataset used in this study comprises of the daily transaction details of all options and optioned stocks traded in the US exchanges, with our sample period running from January 1996 to December 2010.10 The data on stock options and their underlying stocks are respectively obtained from OptionMetrics and CRSP, whilst accounting information on the firms for our analysis on the impact of earnings announcements was also obtained from Compustat.11 The total number of earnings announcement events and the total number of corresponding firms are reported in
Table 1; both of these totals exhibit an increasing trend over time, for example, the total number of events increased from 93 in 1996 to 812 in 2010.