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Slow diffusion of information and price momentum in stocks: Evidence from options markets

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  • Chen, Zhuo
  • Lu, Andrea

Abstract

This paper investigates the source of price momentum in the stock market using information from options markets. We provide direct evidence of the gradual information diffusion model in Hong and Stein (1999): momentum profits are larger for stocks whose information diffuses slowly into the stock market. We exploit the options markets to identify stocks with slow information diffusion speed. As informed traders trade options to realize the information that has not been fully incorporated in the stock price, we are able to enhance the momentum strategy by selecting winner/loser stocks with high growth/large drop in call option implied volatility. Our empirical strategy generates a risk-adjusted alpha of 1.8% per month over the 1996–2011 period, during which the simple momentum strategy fails to perform. The results are robust to the impact of earnings announcement, transaction costs, industry concentration, and choice of options’ moneyness and time-to-maturity. Finally, our finding is not driven by existing stock- or option-related characteristics that are known to improve momentum.

Suggested Citation

  • Chen, Zhuo & Lu, Andrea, 2017. "Slow diffusion of information and price momentum in stocks: Evidence from options markets," Journal of Banking & Finance, Elsevier, vol. 75(C), pages 98-108.
    • Handle: RePEc:eee:jbfina:v:75:y:2017:i:c:p:98-108
    DOI: 10.1016/j.jbankfin.2016.11.010
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    2. Li-Chuan Liao & Tzu-Pu Chang & Ping-Huang Wang, 2023. "Earnings Management Ethicality and Application in the Kenyan Public Sector: A Critical Review," International Journal of Business and Economic Sciences Applied Research (IJBESAR), Democritus University of Thrace (DUTH), Kavala Campus, Greece, vol. 16(1), pages 71-86, October.
    3. Maurice McCourt, 2022. "Permanent private equity: Market performance and transactions," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 45(2), pages 339-383, June.
    4. Yu, Miao & Hu, Xiaolu & Zhong, Angel, 2024. "Network centrality, information diffusion and asset pricing," International Review of Financial Analysis, Elsevier, vol. 93(C).
    5. Patrick Houlihan & Germán G. Creamer, 2017. "Can Sentiment Analysis and Options Volume Anticipate Future Returns?," Computational Economics, Springer;Society for Computational Economics, vol. 50(4), pages 669-685, December.
    6. Mario Enrique Negrete, 2024. "Constant Leverage Covering Strategy for Equity Momentum Portfolio with Transaction Costs," IJFS, MDPI, vol. 12(2), pages 1-25, June.
    7. Jifei Wang & Lingjing Wang, 2019. "Residual Switching Network for Portfolio Optimization," Papers 1910.07564, arXiv.org.
    8. Ellington, Michael & Stamatogiannis, Michalis P. & Zheng, Yawen, 2022. "A study of cross-industry return predictability in the Chinese stock market," International Review of Financial Analysis, Elsevier, vol. 83(C).
    9. Jian Wang & Yanhuang Huang & Hongrui Feng & Xingjian Li & Shu Yan, 2023. "CEO incentive compensation and stock price momentum," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 63(S1), pages 975-1028, April.
    10. Ming‐Yu Liu, 2019. "Improving momentum strategies using residual returns and option‐implied information," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 39(4), pages 499-521, April.
    11. Wouassom, Alain & Muradoğlu, Yaz Gülnur & Tsitsianis, Nicholas, 2022. "Global momentum: The optimal trading approach," Journal of Behavioral and Experimental Finance, Elsevier, vol. 36(C).
    12. Xiaoyue Chen & Bin Li & Andrew C. Worthington, 2022. "Economic uncertainty and Australian stock returns," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 62(3), pages 3441-3474, September.
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    More about this item

    Keywords

    Momentum; Implied volatility;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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