TY - JOUR

T1 - Idiosyncratic volatility, option-based measures of informed trading, and investor attention

AU - Mohrschladt, Hannes

AU - Schneider, Judith C.

N1 - Funding Information: Open Access funding enabled and organized by Projekt DEAL. Financial support from the German Research Foundation (DFG grant number 316058991) is gratefully acknowledged. Publisher Copyright: © 2021, The Author(s).

PY - 2021/10

Y1 - 2021/10

N2 - We establish a direct link between sophisticated investors in the option market, private stock market investors, and the idiosyncratic volatility (IVol) puzzle. To do so, we employ three option-based volatility spreads and attention data from Google Trends. In line with the IVol puzzle, the volatility spreads indicate that sophisticated investors indeed consider high-IVol stocks as being overvalued. Moreover, the option measures help to distinguish overpriced from fairly priced high-IVol stocks. Thus, these measures are able to predict the IVol puzzle’s magnitude in the cross-section of stock returns. Further, we link the origin of the IVol puzzle to the trading activity of irrational private investors as the return predictability only exists among stocks that receive a high level of private investor attention. Overall, our joint examination of option and stock markets sheds light on the behavior of different investor groups and their contribution to the IVol puzzle. Thereby, our analyses support the intuitive idea that noise trading leads to mispricing, which is identified by sophisticated investors and exploited in the option market.

AB - We establish a direct link between sophisticated investors in the option market, private stock market investors, and the idiosyncratic volatility (IVol) puzzle. To do so, we employ three option-based volatility spreads and attention data from Google Trends. In line with the IVol puzzle, the volatility spreads indicate that sophisticated investors indeed consider high-IVol stocks as being overvalued. Moreover, the option measures help to distinguish overpriced from fairly priced high-IVol stocks. Thus, these measures are able to predict the IVol puzzle’s magnitude in the cross-section of stock returns. Further, we link the origin of the IVol puzzle to the trading activity of irrational private investors as the return predictability only exists among stocks that receive a high level of private investor attention. Overall, our joint examination of option and stock markets sheds light on the behavior of different investor groups and their contribution to the IVol puzzle. Thereby, our analyses support the intuitive idea that noise trading leads to mispricing, which is identified by sophisticated investors and exploited in the option market.

KW - Idiosyncratic volatility puzzle

KW - Investor attention

KW - Option-implied volatility spreads

UR - http://www.scopus.com/inward/record.url?scp=85099955465&partnerID=8YFLogxK

U2 - 10.1007/s11147-021-09175-7

DO - 10.1007/s11147-021-09175-7

M3 - Article

AN - SCOPUS:85099955465

VL - 24

SP - 197

EP - 220

JO - Review of derivatives research

JF - Review of derivatives research

SN - 1380-6645

IS - 3

ER -