Non-fundamental Shocks and Implied Volatility Skew : Evidence From S&P 500 Index Inclusions

When stock prices deviate from their fundamental values due to excess demand, investors anticipate reversals and trade in the options market to exploit the temporary misvaluation. This leads to options’ predictability of stock returns beyond the well-known informed trading channel. Using S&P 500 index inclusions, we examine how option prices predict the reversal of a non-fundamental demand shock to the stock price. We find that the implied volatility skew of stocks added to the index becomes steeper in the months following index inclusion. This effect is not caused by an increase in systematic risk or the pre-inclusion momentum of added stocks. It exists only for stocks that experience a high index addition announcement return and fades after the announcement return reverses. Moreover, the implied volatility skew predicts next month’s return for added stocks but this predictability is mainly driven by return reversals