Analyzing market sentiment based on the option-implied distribution of stock returns

Shu Ling Chiang and Ming Shann Tsai

Journal of Risk

Abstract: This paper provides a new measure for assessing market sentiment based on the option-implied distribution of stock returns generated from option data. We also analyze whether this measure is influenced by factors such as the stock price, the trading volume of the option, the option’s open interest, the trading volume of the stock, the volatility of the stock returns, the turnover ratio in the stock market and the put–call ratio. Data from the Taiwanese options market is employed to illustrate the application of the model. The empirical results can be summarized as follows: investors who trade options with longer maturities are more divergent in their expectations about future stock returns than those who trade options with shorter maturities; investors are more optimistic about future stock prices if the current stock price, the stock volatility, the stock and option trading volumes, and the put–call ratio increase; investors tend to be more pessimistic if the open interest and turnover ratio increase; and investors who hold options with longer maturities are more optimistic than investors who hold options with shorter maturities. Our analyses should help portfolio managers and investors better understand market sentiment and should act as guidelines for investment decisions so as to more efficiently optimize complicated portfolios and undertake optimal trading strategies.

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