Why Do Option Prices Predict Stock Returns? The Role of Price Pressure in the Stock Market
We show that option-based predictors of stock returns, such as implied-volatility spreads, skews, and changes therein, are significantly affected by price pressure in the stock market not reflected in option prices. These option-based predictors are transforms of the difference between the option- implied stock value and the traded stock price (DOTS). We find that DOTS is strongly related to return reversals, order imbalances, and illiquidity in stocks, but is only weakly related to trading activity in options. This suggests that price pressure in stocks is an important driver of the stock return predictability derived from option prices.
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