Why Do Option Prices Predict Stock Returns? The Role of Price Pressure in the Stock Market

The distance between option-implied and traded stock prices (DOTS) predicts future stock returns. A trading strategy based on DOTS yields an alpha of 85 basis points on the day after portfolio formation. We show that DOTS is strongly related to return reversals, order imbalances, and transaction costs in stocks, and is only weakly related to trading activity in options. These results are consistent with temporary stock price pressure being an important driver of the option-based return predictability. This significantly affects the interpretation of measures of informed trading based on option-implied volatilities, which are sensitive to pressure in stock prices.