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

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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.

Original languageEnglish
JournalReview of Derivatives Research
Issue number3
Pages (from-to)197-220
Number of pages24
Publication statusPublished - 10.2021

Bibliographical note

Open Access funding enabled and organized by Projekt DEAL. Financial support from the German Research Foundation (DFG grant number 316058991) is gratefully acknowledged.

    Research areas

  • Idiosyncratic volatility puzzle, Investor attention, Option-implied volatility spreads
  • Management studies