Identifying Stock Option Mispricing at a Large Cross Section

Abstract

This paper introduces an innovative two-step approach for identifying implied volatility (IV) mispricing across a large cross-section, moving beyond the traditional volatility forecasting framework. The two-step process disentangles the contributions of historical volatility and other firm-specific characteristics, isolating the residual as the IV mispricing. Different from traditional IV misvaluation proxies, which primarily focus on 1-month at-the-money (ATM) options, our method demonstrates broader applicability. It accommodates options with wider maturities and extends to both ATM and out-of-the-money (OTM) call and put options. Applying a long-short delta-hedged options trading strategy, using the IV mispricing, achieves a high information ratio (IR). When incorporating short- and long-term historical volatility trends as conditions, while returns remain relatively unchanged, portfolio volatility is significantly reduced, further enhancing the IR to 4.093. This approach provides a robust predictive signal for option returns and remains resilient to transaction costs, consistently outperforming alternative signals, as validated through double-sorting analysis.