Option market behavior around the stocks' 52-week highs and lows

This paper extends the research on informed trading in the options market by investigating the reaction of the option market to mispricing in the underlying stock around the 52-week highs and lows. The implied volatility spread, which captures the demand for put options relative to call options, is used to examine the behavior of the options market around the stock price extremes. Regression and quintile analysis are performed to test for the stock return predictability of the implied volatility spread. The results show that comparatively expensive call options predict positive stock returns and comparatively expensive put options predict negative stock returns around the 52-week highs and lows. The predictability is stronger for stocks with a higher probability of informed trading and the results are more significant around the 52-week lows. The evidence implies traders can take advantage of the predictability of the implied volatility spread to develop gainful trading strategies. This is the first paper to examine the relative demand of put and call options around the 52-week highs and lows. This research sheds new light on how the option market and the stock market are segmented and where informed investors trade.