When the Favorite Meets the Underdog: Implied Volatility Spread and Option Returns

Prior literature shows that the implied volatility spread between call and put options is a bullish signal for future returns on the underlying stocks. A common interpretation is that a high call-put implied volatility spread indicates favorable private information revealed by informed option investors. However, this paper finds that a high call-put implied volatility spread is a strong bearish signal for future returns on out-of-the-money call options. Using unique data on daily option volumes, we reconcile the two pieces of seemingly contradicting evidence by showing that demand for options by sophisticated, firm investors drives the positive relationship between volatility spreads and future stock returns, while demand for options by less sophisticated, customer investors drives the negative relationship between volatility spreads and future call option returns. Taken together, our evidence suggests that call-put implied volatility spreads contain information about firm fundamentals as well as option mispricing.