Implied Volatility Sentiment: A Tale of Two Tails

Philip Stork, Luiz Felix and Roman Kräussl
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Luiz Felix: VU Amsterdam, The Netherlands

No 17-002/IV, Tinbergen Institute Discussion Papers from Tinbergen Institute

Abstract: Low probability events are overweighted in the pricing of out-of-the-money index puts and single stock calls. We show that such a behavioral bias is strongly time-varying and is linked to equity market sentiment and higher moments of the risk-neutral density. We find that our implied volatility (IV) sentiment measure, jointly derived from index and single stock options, explains investors' overweight of tail events well. Our IV-sentiment measure adds value over and above traditional factors in predicting the equity risk premium out-of-sample. When employed as a mean-reversion strategy, our IV-sentiment measure delivers economically significant results, which are more consistent than the ones produced by the conventional sentiment factor. We find that our contrarian investment strategy shows 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 avoiding momentum crashes.

Keywords: Sentiment; implied volatility skew; equity-risk premium; reversals; predictability. (search for similar items in EconPapers)
JEL-codes: G12 G14 G17 (search for similar items in EconPapers)
Date: 2017-01-13, Revised 2018-01-26
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Related works:
Journal Article: Implied volatility sentiment: a tale of two tails (2020)
Working Paper: Implied volatility sentiment: A tale of two tails (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:tin:wpaper:20170002

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