Volatility Smirk Predicts Earnings

Is there any information in options? Does it give us clues what the underlying stock will do? Or is it just another casino?

In a discussion titled: “Smirking Because They Know Something” CXO Advisory discusses a paper that concludes that looking at the difference between the implied volatility of Out of The Money (OTM) puts and comparing it to At The Money (ATM) calls, the “smirk” referred to, does have real value.

Here are the main points with my comments.

• Over 90% of sample observations have positive volatility smirks, with OTM put options typically (median) implying volatilities about 5% higher than those implied by ATM call options.
• A portfolio that is long (short) the tenth of stocks with the least (most) pronounced option volatility smirks, rebalanced weekly, generates a risk-adjusted (market, size, book-to-market) annual return of about 15% before transaction costs.

So if you buy the 10% of stocks with the smallest smirk and sell the 10% with the largest smirk and rebalance the portfolio weekly, you may earn 15% before transaction costs.

• This predictability persists with generally diminishing returns for holding (rebalancing) periods up to about six months.

The increased implied volatility of the out of the money put option predicts poor earnings for the company for up to six months out. The paper guesses that is because knowledgeable investors prefer to buy the OTM puts when they know earnings will disappoint. That increased demand increases the implied volatility of the puts.

• Combining a rough approximation of transactions costs with bimonthly portfolio rebalancing suggests that a real trading strategy may well be profitable.
• Firms with steepest option volatility smirks tend to have the worst earnings shocks the next quarter.

So the real value of this volatility skew is for the next quarter’s earnings.

• Predictability is robust to size, book-to-market, idiosyncratic volatility and momentum effects.
• Results are consistent with an interpretation that: (1) informed traders with bad news prefer OTM put options; and, (2) the stock market is slow to incorporate the information they reveal.

Now that we know this, will the effect go away?