Exploiting Option Information in the Equity Market

Public option market information contains exploitable information for equity investors for an investable universe of liquid large-cap stocks. Strategies based on several option measures predict returns and alphas on the underlying stock. Transaction costs are an important factor given the high turnover of these strategies, but significant net alphas can be obtained when using a simple approach that reduces transaction costs. These findings suggest that information diffuses gradually from the option market into the underlying stock market. In our study, we examined whether public information contained in the option market predicts cross-sectional stock returns for a well-investable universe of highly liquid U.S. large-cap stocks and, thus, provides valuable, exploitable information for equity investors. We found that trading strategies based on worries about negative price movements (i.e., out-of-the-money volatility skew), volatility risk (i.e., realized versus implied volatility spread), informed trading and jump risk (i.e., at-the-money volatility skew), and the change in informed trading (i.e., the change in the at-the-money volatility skew) yield significant returns and alphas. The performances remain significant after correcting for market, size, value, momentum, reversal, and other return-predicting factors. Hence, we found that these strategies are substantially different from other well-known stock selection strategies.Further, a combined option information strategy shows even stronger results, with an annualized performance of around 10%, thereby strengthening the relevance of the publicly available information contained in option prices for equity investors. Although several studies have reported that the predictive power of option market variables decreases over time, we found significant returns also in recent out-of-sample years. These results are robust for bull, bear, volatile, and calm markets and are generally of similar magnitude for stocks with low or high information uncertainty.Exploiting the option information measures requires an extremely high turnover. Therefore, all profitability is estimated to be consumed by transaction costs in our investable universe. However, when we used our strategy on the largest 100 stocks—stocks that generally have the lowest transaction costs—and applied simple turnover-reducing portfolio construction rules, we found economically and statistically significant net returns above 7% a year for the long–short portfolio. This finding leads us to conclude that the documented strategies are exploitable by practitioners and suggests that information diffuses gradually from the equity option market into the underlying stock market.