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1 June 2014 CFA Institute Journal Review

Call-Put Implied Volatility Spreads and Option Returns (Digest Summary)

  1. Thomas M. Arnold, CFA

In their investigation of the relationship between the call–put implied volatility spread (CPIV) and the underlying stock price, the authors determine that the CPIV is a bullish signal for the stock price. But a long–short portfolio of out-of-the-money call options generates significantly negative returns based on the CPIV, which may be the result of trading by unsophisticated retail investors.

What’s Inside?

Researchers find that the call–put implied volatility spread (CPIV)—that is, the implied volatility of call options less the implied volatility of put options of similar moneyness and maturity, weighted by open interest across moneyness—is positively related to the return of the underlying stock one month (26 days) into the future. Considering only out-of-the-money call options based on the CPIV reveals a negative relationship between the CPIV and the return on the option.

This “confounding relationship” appears to be the result of sophisticated (i.e., institutional) traders driving the positive relationship early in the 26-day window and unsophisticated (i.e., retail) traders driving the negative relationship later in the 26-day window, using primarily out-of-the-money call options. The sophisticated traders tend to dominate the unsophisticated traders overall.

How Is This Research Useful to Practitioners?

Based on these findings, traders can form long–short portfolios of stocks based on CPIV (i.e., going long high-CPIV stocks and short low-CPIV stocks) to generate a monthly return in excess of the S&P 500 Index. These returns cannot be explained by other firm-specific factors or other market factors. Similarly, a long–short portfolio in out-of-the-money call options based on CPIV (i.e., going long low-CPIV out-of-the-money call options and short high-CPIV out-of-the-money call options) will produce a monthly return in excess of the S&P 500. A combined strategy—using the option strategy for 10% of the portfolio—does even better.

Another way to view the findings is relative to how sophisticated and unsophisticated traders differ based on option volume. Sophisticated traders tend to trade early within the 26-day horizon and then move toward at-the-money options as maturity approaches. Consistent with behavioral explanations, unsophisticated traders tend to trade out-of-the-money call options, and option predictability becomes more pronounced as maturity approaches. Sophisticated investors tend to trade rationally on favorable private information, whereas unsophisticated investors tend to overreact to movements in option prices. This mispricing leads to the negative relationship between CPIV and out-of-the-money call option prices.

How Did the Authors Conduct This Research?

The authors use daily option data from January 1996 through October 2009 for options with one month to expiration. Using a 26-day horizon, they calculate the CPIV and sort the underlying stocks into quintiles. Portfolios formed using the CPIV sort (long stocks with high CPIV and short stocks with low CPIV) are held for 26 days, until close to the option’s expiration. The CPIV sort is then used to examine how options of different moneyness categories performed over the 26-day horizon. It is in this analysis that the negative relationship between the CPIV and out-of-the-money call options is evident.

Daily option volume data for May 2005 through October 2009, to allow the authors to differentiate between sophisticated and unsophisticated investors, are obtained from ISE (International Security Exchange). When these data are incorporated into the CPIV-sorted data, the patterns of sophisticated and unsophisticated traders emerge within the 26-day horizon.

The authors perform a number of robustness checks to ensure that another risk factor cannot explain the findings.

Abstractor’s Viewpoint

I find the authors’ results intriguing and wonder whether such long–short strategies have emerged as a result of their article. I am also interested in whether the results of longer-term options could add to this analysis.

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