The Information Content of The Implied Volatility Surface: Can Option Prices Predict Jumps?

We ask whether option prices contain information on the likelihood and direction of jumps in the underlying stock prices. Applying the partial least squares (PLS) approach to the entire surface of the implied volatilities (IV), we show that option prices can successfully predict downward jumps in stock prices, but not upward jumps. The PLS estimated downward jump factor can predict stock returns with a spread of 1.53% per month between stocks predicted to have the lowest probability of downward jumps and stocks predicted to have the highest probability of downward jumps. Both put and call option prices, and options of both short and long maturity contribute to the predictability. Furthermore, the predictability of the downward jump is robust to many firm characteristics as well as options related variables. Consistent with the notion that informed investors trade in the options markets to profit from negative information in order to circumvent the short-sale constraint, we find that stronger predictability is associated with tighter short-sale constraints in the equity market, and in periods when the market has poor performance.