Bid and Ask Prices of Index Put Options: Which Predicts the Underlying Stock Returns?

Abstract

In this study, we separately estimate the implied volatility from bid prices and ask prices of
deep out-of-the-money (OTM) put options on the S&P500 index. We find that the implied
volatility of ask prices has stronger stock return predictability than that of bid prices. Our finding is robust to the out-of-sample setting and this superior predictive power leads to great economic values in the asset allocation. The better performance of the ask price implied volatility relative to that of the bid price is largely due to its stronger power for predicting stock returns during the state of economic recession and the state of increasing intermediary capital risk. In particular, in the presence of intermediary shock, the ask price implied volatility contains richer information related to the market variance risk premium than does the bid price implied volatility.