What info does option-implied skewness include, and the way is it associated to the momentum anomaly?
Gurdip Bakshi, Nikunj Kapadia, and Dilip B. Madan created estimators for option-implied moments of the distribution of the returns to the underlying asset, and launched a broad and ongoing investigation of this distribution’s info content material that focuses on the uneven third second of skewness.
To date, these explorations discover at occasions contradictory proof concerning the info content material of option-implied risk-neutral skewness (RNS), the third second of this distribution. High positive RNS has been said to have a negative relationship with returns due to behavioral preferences for lottery stocks and a positive relationship due to low RNS proxying for overvaluation, particularly in the presence of short-sale constraints.
To shed extra gentle on this problem, assist resolve probably contradictory findings, and higher perceive the knowledge channel, we examined the relationship of RNS to both the past and future price path of stocks.
We discover that contemporaneous RNS estimated on the finish of the month has a optimistic correlation with returns for the underlying inventory over the next month. An equal-weighted zero-cost portfolio kind on excessive (i.e., most optimistic) minus low (most unfavourable) RNS reveals vital irregular returns of 94 bps, of which 39 bps is as a result of quick leg. This result’s in step with the overvaluation explanation superior by prior research.
Nevertheless, the remaining 55 bps is as a result of lengthy leg, which doesn’t match the reason. Moreover, a value-weighted equal excessive minus low RNS portfolio has irregular returns of roughly 70 bps, with 48 bps as a result of lengthy and 21 bps as a result of quick leg. Throughout each portfolio weightings, the larger magnitude of the surplus and irregular return contribution of the high-RNS lengthy leg suggests that there’s extra to the RNS anomaly than the extant overvaluation rationalization of the RNS anomaly that focuses on the quick leg. Certainly, we discover that the valuation channel proposed for low-RNS shares works each methods, and that high-RNS shares are comparatively undervalued, explaining their upward value rebounds within the determine under. Moreover, we discover that the lengthy leg of the zero-cost high-low RNS portfolio has a optimistic and vital conditional beta throughout market rebounds whereas the quick leg doesn’t, suggesting a dynamic that overvaluation underneath short-sale constraints doesn’t seize.
Based mostly on these findings, we suggest another rationalization to the RNS anomaly as an indicator of inventory value rebounds, immediately tying it to the momentum crash phenomenon in which a reversal of trends causes a reversal in the momentum anomaly.
Path-Dependent Relationship between RNS and Underlying Month-to-month Returns
Path-dependent relationship between RNS and underlying month-to-month returns. The Quintile 5 portfolio comprises shares with probably the most optimistic option-implied skewness on the finish of month 0, whereas Quintile 1 comprises the bottom.
The above graphic demonstrates the path-dependence of RNS with respect to the previous and future efficiency of the underlying inventory. On the finish of every portfolio formation month (t=0), we rank shares into RNS quintiles, type portfolios, and plot the portfolio’s previous and future equal-weighted extra returns for low RNS Q1 and excessive RNS Q5.
The chart reveals that each excessive and low RNS shares expertise reversals of their efficiency. The Q1 shares have good historic efficiency earlier than portfolio formation and poor efficiency after. Conversely, the Q5 shares exhibit unfavourable efficiency earlier than portfolio formation and a optimistic rebound afterward. The Q1 portfolio’s conduct is in step with the reason of worse future efficiency by overvalued and short-sale–constrained shares. However the Q5 portfolio’s optimistic rebound is just not.
Per the pattern reversal of unfavourable momentum shares noticed within the RNS Q5 portfolio, we discover that the RNS anomaly isolates the impact of momentum crashes. Daniel and Moskowitz present that momentum methods endure rare unfavourable returns which are persistent, particularly on the finish of market recessions, and excessive market volatility intervals as low-momentum shares rebound. The market beta of the momentum technique turns into extra unfavourable in excessive market stress intervals, giving it uneven unfavourable publicity to the rebound. We discover that the RNS anomaly has a optimistic beta throughout market-wide rebounds, giving it an reverse uneven optimistic publicity.
Based mostly on its unfavourable relationship with momentum returns, we theorize that the RNS anomaly picks up momentum crashes. We display this by forming a winner minus loser momentum technique inside RNS terciles and discovering vital variations in its efficiency throughout them.
The momentum technique within the excessive RNS tercile experiences probably the most extreme crashes round market rebounds following recessionary intervals. Controlling for dimension, we discover that for all however the smallest tercile of shares, the momentum technique earns the bottom returns in recessions and intervals of excessive market volatility within the highest RNS tercile. Conversely, the bottom RNS tercile yields the strongest momentum efficiency (the fewest momentum crashes) for each median and enormous corporations.
To generalize this discovering to shares with out traded choices essential to compute the RNS attribute, we assemble a characteristic-mimicking portfolio utilizing optionable shares. This enables us to deal with a bigger universe of tradeable belongings, which each will increase the financial significance of our discovering in addition to its robustness.
By eliminating the requirement that shares have the traded choices essential to compute the RNS attribute, we take away a possible choice bias in our outcomes. We hypothesize that non-optionable shares with comparable value rebound patterns may have publicity to this factor-mimicking portfolio constructed from optionable shares predicted to have value rebounds from a kind on the RNS attribute, and discover proof in step with this speculation.
Shares with a excessive RNS attribute, in addition to these with a excessive skewness characteristic-mimicking portfolio loading, have considerably extra frequent optimistic efficiency reversals on the particular person agency degree pushed by a response to previous undervaluation. Loadings on the skewness factor-mimicking portfolio predict future realized skewness, in step with its effectiveness as a proxy for RNS. Moreover, a momentum technique on shares with the bottom skewness factor-mimicking portfolio loadings has considerably improved efficiency, confirming the RNS attribute’s skill to determine and keep away from the momentum crash phenomenon as proven within the desk under:
Extra Return Momentum Decile
Efficiency of the momentum technique throughout quintiles of publicity to the option-implied skewness factor-mimicking portfolio SKEW. Momentum is outlined following Robert Novy-Marx however is strong to different specs.
These outcomes will not be pushed by small, illiquid, or excessive buying and selling value shares. The development within the risk-return tradeoff of the momentum technique launched by avoiding momentum crashes with low-RNS shares is extra vital than that of the risk-managed momentum technique advised by Pedro Barroso and Pedro Santa-Clara. This suggests the efficiency reversal info captured within the RNS attribute has significant financial worth.
It additionally demonstrates that momentum crashes will be recognized and prevented, considerably bettering the technique’s efficiency. We display that top RNS shares predict optimistic inventory efficiency, notably after a interval of underperformance, and this reversal has a relationship with the momentum crash phenomenon documented by Daniel and Moskowitz. We observe this conduct utilizing each the RNS traits in optionable shares in addition to all CRSP shares no matter optionability utilizing inventory loadings on our novel constructed risk-neutral skewness issue.
Threat-neutral skewness issue loadings present a easy technique to keep away from momentum crashes in an economically vital manner and display the RNS anomaly’s relationship with value rebounds and momentum crash threat. These findings bolster our understanding of the knowledge content material of the option-implied skewness of the distribution of underlying inventory returns.
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