Do Option Characteristics Predict the Underlying Stock Returns in the Cross-Section?
Abstract
We provide a comprehensive analysis of option-implied information for predicting the cross-section of stock returns. Based on large sets of firm and option characteristics and using traditional portfolio sorts and modern high-dimensional methods, we find that option information matters. However, in contrast to existing studies, there are only a few option characteristics that have significant incremental predictive power after controlling for the large set of firm characteristics. Further analysis reveals that the strongest option characteristics are associated with asset mispricing, future tail return realizations, and short-selling costs. Our findings are consistent with models of informed trading and limits to arbitrage.
This paper was accepted by Lin William Cong, finance.
Funding: R. T. Varneskov gratefully acknowledges financial support from the Danish Finance Institute (DFI) and the Center for Big Data in Finance [Grant DNRF167].
Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2024.04720.
