What Does Risk-Neutral Skewness Tell Us About Future Stock Returns?

This study documents a positive relationship between the option-implied risk-neutral skewness (RNS) of individual stock returns’ distribution and future realized stock returns during the period 1996–2012. A strategy that goes long the quintile portfolio with the highest RNS stocks and short the quintile portfolio with the lowest RNS stocks yields a Fama–French–Carhart alpha of 55 basis points per month (t-statistic of 2.47). The significant underperformance of the portfolio with the most negative RNS stocks is driven by those stocks that are also perceived as relatively overpriced according to a series of overvaluation proxies and are too costly or too risky to sell short, thereby hindering the price correction mechanism. Our findings indicate that a highly negative RNS value, when reflecting high hedging demand for options by investors who perceive the underlying stock as relatively overpriced but hard to sell short, is a robust signal of significant future stock underperformance.

This paper was accepted by Jerome Detemple, finance.