Implied volatility sentiment: a tale of two tails |
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Authors: | Luiz Félix Roman Kräussl Philip Stork |
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Institution: | 1. APG Asset Management, Gustav Mahlerplein 3, 1082 MS Amsterdam, Netherlands;2. School of Business and Economics, VU University Amsterdam, de Boelelaan 1105,1081 HV Amsterdam, Netherlandsluizfffelix@yahoo.com;4. Luxembourg School of Finance, University of Luxembourg, 4, rue Albert Borschette, 1246 Luxembourg, Luxembourg;5. Tinbergen Institute Amsterdam, Gustav Mahlerplein 117, 1082 MS Amsterdam, Netherlands;6. School of Business and Economics, VU University Amsterdam, de Boelelaan 1105,1081 HV Amsterdam, Netherlands |
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Abstract: | We propose a sentiment measure jointly derived from out-of-the-money index puts and single stock calls: implied volatility (IV-) sentiment. In contrast to implied correlations, our measure uses information from the tails of the risk-neutral densities from these two markets rather than across their entire moneyness structures. We find that IV-sentiment measure adds value over and above traditional factors in predicting the equity risk premium out-of-sample. Forecasting results are superior when constrained ensemble models are used vis-à-vis unregularized machine learning techniques. In a mean-reversion strategy, our IV-sentiment measure delivers economically significant results, with limited exposure to a set of cross-sectional equity factors, including Fama and French's five factors, the momentum factor and the low-volatility factor, and seems valuable in preventing momentum crashes. Our novel measure reflects overweight of tail events, which we interpret as a behavioral bias. However, we cannot rule out a risk-compensation rationale. |
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Keywords: | Sentiment Implied volatility Equity-risk premium Reversals Predictability Machine learning |
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