Following is a summary of their findings:
- There’s a monotonically positive relationship between call ratios and the last quarter’s total skewness. Similar results are found when examining the relationship between call ratios and last-quarter’s idiosyncratic skewness.
- There’s a significantly positive univariate (dependent on one variable) correlation between call ratios and last-quarter’s skewness. When using the indicator variable approach, they found similar results. In particular, call ratios are highest when last quarter’s skewness is highest.
- When approximating stock lotteries using low-priced stocks with the highest idiosyncratic volatility and the highest idiosyncratic skewness, they found that call ratios are highest for these stocks.
- There’s a robust positive relation between call ratios and the authors’ approximations for lottery stocks.
Blau, Bowles and Whitby concluded: “These results support our univariate tests and indicate that investors’ penchant for lottery stocks is also reflected in higher call ratios.”
They also concluded: “Speculative call option activity, or the portion of the call ratio that is directly related to lottery-like stock characteristics, drives the direct relation between total call ratios and next-quarter volatility. To the extent that higher call ratios in lottery-type stocks represent speculative activity in the options market, our results are consistent with theory which posits that speculative trading activity in the derivatives market can lead to increased volatility.”
What It Means For Investors
For investors, the implications are striking. The authors write: “Skewness preferences can result in an equilibrium that leads to overpriced, positively skewed stocks. Price premiums that are caused by skewness preferences will underperform stocks that are not positively skewed.”
The evidence they present also demonstrates that the availability of derivatives, such as call options, can allow investors to express their preference for skewness, which in turn can drive volatility and influence returns. This may also lead to greater levels of speculation in derivatives markets, which could produce noisy prices adversely affecting “the ability of informed investors to transmit information into prices, thus leading to greater instability of prices.”
These findings also have implications for portfolio construction. First, investors buying individual stocks should avoid those with lotterylike characteristics. Second, mutual funds can improve performance by screening out stocks with these negative traits.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.