Sources of Volatility's Predictive Power for Stock Returns

November 14, 2007

Past research finds that stocks with low (high) short-term historical volatility tend to outperform (underperform). What causes this relationship? In the November 2007 update of their paper entitled "Volatility Spreads and Expected Stock Returns", Turan Bali and Armen Hovakimian examine the similarities and differences between realized (historical) volatility and implied volatility in the context of power to predict stock returns. Using stock price/fundamentals data for a broad range of stocks and volatilities implied by associated options with near-term expiration dates over the period January 1996-January 2005, they find that:

• Confirming past research, a hedge strategy that is long (short) the 20% of stocks with the highest (lowest) one-month lagged realized volatilities generates significantly negative returns (an average alpha of -1.5% per month).
• However, a similar trading strategy based on implied volatilities derived from the prices of options generates insignificant returns.
• The difference between realized volatility and implied volatility reasonably represents volatility risk. A hedge strategy that is long (short) the 20% of stocks with the lowest (highest) realized-implied volatility difference produces average raw and risk-adjusted returns of 0.5% to 0.9% per month.
• The difference between the volatility implied by call options and the volatility implied by put options reasonably reflects the expected future price change of the underlying stock. A hedge portfolio that is long (short) the 20% of stocks with the highest (lowest) call-put implied volatilities earns highly significant raw and risk-adjusted returns of 1.1% to 1.4% per month.
• These results persist after controlling for size, book-to-market, liquidity, analyst earnings forecast dispersion, probability of informed trading and skewness.

In summary, volatility-based portfolio strategies derive their effectiveness from: (1) the difference between realized volatility and implied volatility ; and, (2) the difference between call-implied volatility and put-implied volatility.