Differences of Opinion Predict Volatility

As a new test of models of differences of opinion, we study empirically how the shorting market interacts with the equity volatility. Consistent with theories of differences of opinion, a positive (negative) demand shift in the shorting market predicts higher (lower) future stock volatility: A positive demand shift predicts an increase in the next week's annualized volatility of 4.8 percentage points, which corresponds to a 10.9% increase relative to the average weekly annualized volatility. The effect remains after controlling for other proxies of differences of opinion such as bid-ask spreads and volume, suggesting that the shorting market is an important channel in which investors reveal divergence or convergence in their beliefs about the future trajectory of individual stocks.