The Dynamics of Option Volatility Smirk and Option Returns Predictability: Evidence From Chinese SSE50 ETF Options

Abstract

We examine the predictive ability of risk-neutral moments extracted from option volatility smirks for the option delta-neutral returns using the SSE50 ETF stock index option. We find risk-neutral skewness changes over market conditions. The risk-neutral skewness significantly predicts 1-day, 2-day, and 1–4 weeks ahead call option returns with negative signs in both in-sample and out-of-sample tests. The results are robust in including other control variables and different constant maturity risk-neutral skewnesses. Trading strategies based on the predictive model yield a potential maximum annual return of 293%.