Implied Volatility Changes As Evidence Of Stock Price Disequilibrium

Past works have documented the predictive power of short-term stock return momentum and option volume ratios for future stock returns. In this article, the authors find option volume ratios have greater power to predict future returns when evidence exists that prices are out of equilibrium, proxied for by increases in implied volatility. In the studied sample, short-term momentum has significant power to predict future stock returns only in the presence of evidence prices are out of equilibrium. The authors document that option volume ratios, changes in option implied volatility, and short-term momentum together have significant predictive power for the cross-section of stock returns in subsequent periods. The difference between firms predicted to be strong performers and those predicted to be weak performers is more than 1% a month. Buy-and-hold returns for an equally weighted portfolio of predicted strong performers are 249% over the 1996–2009 period compared with a loss of 38% for predicted weak performers. Su0026P 500 Index returns over the same period were 60%.