Idiosyncratic Volatility and Liquidity Risk: How they have Explanatory Power in Stock Returns

Literatures have shown that idiosyncratic volatility and liquidity risk calculated from stock markets have explanatory power in stock returns. However, only few studies focus on the stock option markets. As we know that stock options with high leverage and low costs may attract investors who contain more information. In this study, we use option trading volume as a liquidity factor to reexamine the relationship among liquidity risk, idiosyncratic volatility and stock returns. In addition, we use call and put options trading volume separately to have further discussion. The results show that high idiosyncratic volatility firms produce higher returns and firm size is negatively correlated with stock returns because of the size effect. However, call options and put options imply different signals. Stock returns are increasing with the level of call options and decreasing in put options. This is a result of the differing trading signals that call options and trading options convey. Furthermore, we changed the firm size data from that at the end of the previous year to that at the end of the previous month and eliminated outliers (the first and last 1 % of the data), to perform a robustness test. The empirical results were unaffected.JEL classification numbers: G11; G12; G14; C61Keywords: Idiosyncratic Volatility; Liquidity measures; Individual Stock Options;