Why Do Option Prices Predict Stock Returns

Disagreement between the stock and options markets about the stock’s value can reflect both informed trading in options and temporary price pressure in stocks. We document that the dis-agreement is strongly related to return reversals, order imbalances, and illiquidity in stocks, and weakly related to trading in options. We conclude that stock price pressure is the primary driver of disagreement and of the resultant strong option-price based predictability in stock returns. Implied volatility measures previously interpreted as capturing informed trading in options are direct transformations of the price discrepancy between the two markets and similarly capture price pressure in stocks.