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Using Options Implied Volatility to Predict Returns

The price of an option (e.g., an option on a stock, for example) can
be calculated from its current price, the strike price, the option
period and its volatility (e.g., a.k.a. standard deviation).

The price of the stock (when the option is purchased or sold), the
strike price and the option period are known factors. Volatility is a
more complicated. If volatility is calculated from historical data, it
is defined by a sample: a time period over which the volatility is
calculated.

The actual options prices that are quoted in the market frequently do
not match the historical volatility. Options prices are derived from an estimate
of future volatility. This estimate reflects the market maker's,
presumably informed, estimate of volatility and the chance that the
option may be exercised.

Several papers have speculated that implied volatility can be used as
a predictor for the future returns of the underlying asset. This speculation
is based on the idea that options implied volatility embodies informed
information about the future.

As part of a 1-unit independent study project in graduate school
(Computational Finance and Risk Management at the University of
Washington) I did a project that investigated whether S&P 500 options
implied volatility could be used to predict S&P 500 returns. For the
impatient reader: the answer appears to be no. Implied volatility
factors have no statistical significance in predicting 1-week ahead
returns, at least for the S&P 500.

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Reference Journal Article

Although several papers have suggested that options volatility is a
predictor of future returns, the paper I choose to work from was *Exploiting
Option Information in the Equity Market* by Guido Baltussen,
Bart van der Grient, Wilma de Groot, Erik Hennink and Weili Zhou,
Financial Analysts Journal, Vol 68, No. 4 (July/August 2012).

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Independent Study Results

My independent study results can be found here.

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R Code

The R code that was written to process the options data (from
OptionMetrics) can be found here.

Unfortunately the options data that was used in this study is
propretary and cannot be redistributed so I can't provide this
data. The data was originally obtained from OptionMetrics.

Ian Kaplan

June, 2013

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