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The Put/Call Disparity May Be Telling You Something


But in practice, it's a very difficult situation to identify.


That put/call disparity may be telling you something, says a new academic paper (hat tip: Abnormal).

Previous research documents that deviations from put-call parity can predict stock returns. If the trading activity of informed investors is an important driver of deviations from put-call parity, then the predictability of stock returns should be more pronounced during major information events. This paper investigates whether the predictability of equity returns by deviations from put-call parity is stronger during earnings announcement periods. These deviations are measured by the implied volatility spreads between pairs of matched put and call options. During a two-day earnings announcement window, the abnormal returns to a portfolio that buys stocks with relatively expensive call options is about 2% greater than the abnormal returns to a portfolio that buys stocks with relatively expensive put options. This result is robust after (i) measuring deviations from put-call parity in alternative ways, (ii) using value-weighted portfolio returns, and (iii) controlling for contemporaneous and lagged risk factors and lagged stock returns. The degree of announcement return predictability is stronger when (i) deviations from put-call parity are measured using more liquid options, (ii) information environment is more asymmetric, and (iii) stock liquidity is low.

To review, put/call parity refers to the arb between buying (selling) a call, selling (buying) a put of the same strike and expiration, and shorting (buying) the underlying stock. In parity, the combo would produce a net return of zero when factoring in cost of carry (dividends and interest). In disparity, one side overprices. There can be a simple reason, such as inability to short stock, or a more complex one such as huge demand for either the calls or the puts that the markets literally can't get the other side in line.

The author suggests that when this persists, you have about a 2% edge playing in that direction.

I buzzed through it, and really have no critique, other than it's a real tough situation to identify in practice and I'm not sure it's any different from just finding spots with excess and odd volume tilted to one side.

It's actually similar to something we saw in the Bloomberg article yesterday on the dollar call demand. I refer to this quote.

The so-called 25-delta risk-reversal rate, which was flat as recently as October, hasn't shown such high relative demand for dollar calls since hitting a record 2.595 percentage points in November 2008. When the implied volatility of dollar calls exceeds puts, like now, the gap is expressed as a negative number, which would be minus 2.595 percentage points. The rate touched minus 1.67 percent today.

I've seen this on SPX options too, referred to as a "mirror." You take an OTM call and compare the price to an OTM put of identical delta. If one is abnormally high relative to the other, it suggests sentiment tilting too far in one direction.

The crucial difference is the former case, the academic paper, looks at it as smart money whereas the latter is broader and more of a contrary tell.

Bottom line is heavy and skewed activity in an individual name should at least suggest we consider that its smart money. But if it's a broader asset, like an index or commodity, it's more likely sentiment gone too far. Notable exception being that jobs report the other day.

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