Implied volatility sentiment: a tale of two tails

Luiz Félix, Roman Kräussl and Philip Stork

Quantitative Finance, 2020, vol. 20, issue 5, 823-849

Abstract: We propose a sentiment measure jointly derived from out-of-the-money index puts and single stock calls: implied volatility (IV-) sentiment. In contrast to implied correlations, our measure uses information from the tails of the risk-neutral densities from these two markets rather than across their entire moneyness structures. We find that IV-sentiment measure adds value over and above traditional factors in predicting the equity risk premium out-of-sample. Forecasting results are superior when constrained ensemble models are used vis-à-vis unregularized machine learning techniques. In a mean-reversion strategy, our IV-sentiment measure delivers economically significant results, with limited exposure to a set of cross-sectional equity factors, including Fama and French's five factors, the momentum factor and the low-volatility factor, and seems valuable in preventing momentum crashes. Our novel measure reflects overweight of tail events, which we interpret as a behavioral bias. However, we cannot rule out a risk-compensation rationale.

Date: 2020
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Related works:
Working Paper: Implied Volatility Sentiment: A Tale of Two Tails (2018)
Working Paper: Implied volatility sentiment: A tale of two tails (2017)
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DOI: 10.1080/14697688.2019.1696018

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