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Deviations from Put-Call Parity and Stock Return Predictability

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What they found

The authors measured the gap between implied volatility of calls and puts with the same strike and maturity, which should be zero under put-call parity. Stocks whose calls were relatively expensive (positive volatility spread) went on to outperform those whose puts were relatively expensive by about 50 basis points per week from 1996 to 2005. The predictability was stronger when the spread had recently widened and in stocks with higher options volume, consistent with informed traders leaving footprints in option prices before the stock moved.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Bid-ask spread in an order bookSell orders stacked above buy orders with a gap between the best of each.SELLERS (asks)50.0690050.051,40050.0460050.011,10050.002,30049.99800spread = 0.03BUYERS (bids)
The bid-ask spread. Buy orders sit below, sell orders above, and the gap between the best bid (50.01) and best ask (50.04) is the spread you pay to cross. Bar length shows the size resting at each price.

What you can use

  • When calls are priced richer than puts on the same stock, the stock has tended to rise over the following week, and vice versa.
  • The volatility spread between calls and puts is a cheap, observable measure of option-market sentiment.
  • The effect is concentrated in stocks with active options markets and decays quickly.

Caveats

Weekly rebalancing of a long-short portfolio; returns are gross of costs and short-sale constraints. The effect has weakened since publication.

Tags: options, put-call-parity, implied-volatility, predictability

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.