2009 Headlines
Professor David Weinbaum Finds Predictability in Stock Returns
Award-winning study reveals that option prices hold clues
January 27, 2009 | Ithaca, NY | The stock market may seem anything but predictable these days, but a soon-to-be-published study by Johnson Graduate School of Management Assistant Professor David Weinbaum reveals that option prices can offer important clues about future stock returns.
Weinbaum and fellow researcher Martijn Cremers of the Yale School of Management determined that option prices contain information not yet fully incorporated in stock prices. Furthermore, they report, stock prices can lag option prices by days, not the mere minutes that might be expected of markets that close soon after one another each day. Until the market adjusts, it is possible to infer information from option prices to generate stronger stock returns.
Examining ten years of data spanning January 1996 through December 2005, Weinbaum and Cremers found strong evidence that deviations from put-call parity provide economically and statistically significant information about future stock returns. To measure these deviations, they looked at the difference in volatility between options to sell and buy the same underlying stock, and with the same exercise price and expiration date.
Their study showed the deviations could predict both unexpectedly strong and unexpectedly weak future returns. In their analysis, stocks with relatively expensive calls, or purchase prices, outperformed stocks with relatively expensive puts, or selling prices, by 50 basis points per week.
This predictability, according to Weinbaum and Cremers, produces results that cannot be explained solely by constraints on short sales, which can make stocks overpriced and future returns lower. The predictability does, however, reflect substantial trading in the options market by informed investors and their influence on option prices.
The professors report these findings in the paper "Deviations from Put-Call Parity and Stock Return Predictability," which will appear in a forthcoming issue of the Journal of Financial and Quantitative Analysis. In November 2008, this paper placed first among several hundred entries for the Wheeler Award for Quantitative and Behavioral Research in Finance, presented by Numeric Investors to recognize outstanding research in the field of quantitative equity investing. Earlier, the same paper earned a third-prize Crowell Memorial Award from PanAgora Asset Management.
Weinbaum and Cremers provide reason for caution in weighing the predictability too heavily in trading decisions, however. Wondering why stock prices didn't respond immediately to information that options trading revealed, they analyzed the data more closely, dividing their sample into two five-year periods. That led to their final finding: the degree to which option prices predicted future stock returns had declined over time.
As investors began to recognize the predictability, they sought to exploit it. In turn, stock prices adjusted. And that correction, the professors conclude, suggests market forces eventually prevail, limiting the mispricing of assets.
"We don't see the predictability going away completely. There are still people who have better information than others," says Weinbaum. "But it becomes more difficult to exploit the strategy financially."
