The Joint Cross Section of Stocks and Options

Stocks with large increases in call (put) implied volatilities over the previous month tend to have high (low) future returns. Sorting stocks ranked into decile portfolios by past call implied volatilities produces spreads in average returns of approximately 1 % per month, and the return differences persist up to six months. The cross sec-tion of stock returns also predicts option implied volatilities, with stocks with high past returns tending to have call and put option contracts that exhibit increases in implied volatility over the next month, but with decreasing realized volatility. These predictability patterns are consistent with rational models of informed trading. OPTIONS ARE REDUNDANT ASSETS only in an idealized world of complete markets with no transactions costs, perfect information, and no restrictions on shorting. Not surprisingly, since in the real world none of these assumptions hold, options are not simply functions of underlying stock prices and risk-free securities.1 We show that the cross section of option volatilities contains information that forecasts the cross section of expected stock returns, and the cross section o