Implied Volatility Spread and Stock Mispricing

Zhen Cao, Surya Chelikani, Osman Kilic and Xuewu (Wesley) Wang

Journal of Behavioral Finance, 2024, vol. 25, issue 1, 79-91

Abstract: Stocks can be mispriced for at least two reasons: value-relevant information is not timely incorporated or investor sentiment can induce mispricing. Using the mispricing measure proposed by Stambaugh, Yu, and Yuan (2015), we show that informed trading in the options market, proxied by the implied volatility spread, can substantially alleviate stock mispricing. Higher implied volatility spread reliably predicts subsequently lower stock mispricing after controlling for an array of economic variables including firm size, illiquidity, idiosyncratic volatility, institutional ownership, and investor’s divergence of opinions. In addition, this effect is more pronounced when the options trading volume is higher, consistent with the notion that higher options trading volume provides better camouflage for informed trading in the spirit of Kyle (1985). Our findings highlight the importance of information incorporation to reduce asset mispricing. We further show that a self-financing monthly portfolio that goes long on most underpriced stocks and short on most overpriced stocks when the implied volatility spread is the lowest yields statistically and economically significant abnormal returns.

Date: 2024
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DOI: 10.1080/15427560.2022.2085278

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