Essays on stock return predictability

Abstract

The dissertation consists of three essays on stock return predictability. The first essay studies the effect of the nearness to 52-week highs on momentum crash. The essay documents that contemporaneous with the market rebound, stocks far from 52-week highs outperform stocks near 52-week highs. More importantly, such outperformance explains most part of momentum crashes. Furthermore, this contributes substantially to time-variation and fat tailed distribution of unconditional momentum profits. Empirical evidence is consistent with Baker and Wurgler (2007) who document outperformance of speculative stocks contemporaneous with surge in investor sentiment. The essay’s finding extends to Japan, the United Kingdom, and continental Europe. The second essay studies anomaly profits and option volume. The essay document a strong, positive relation between stock market anomaly returns and trading activity in options, inconsistent with the idea that options trading improves the informational efficiency of the stock market. Moreover, the positive relation between option volume on anomaly returns concentrates in stocks with high short-selling constraints. Additional analyses suggest that the negative joint effect of option volume and overpriced stocks on future stock returns is driven by high investor disagreement associated with heavy option trading rather than intensive informed trading in options. The third essay studies insider trading and option volume. The essay documents that informed trading in option can be utilized to identify informed insider trades. When option volume is low (high) around insider purchase, it is followed by large (near-zero) price increase. Such pattern does not manifest for insider sales, where trading motive is mostly driven by diversification, rebalancing and liquidity needs rather than information. This is consistent with the notion that information set of option investors overlaps with that of insiders, which does not immediately get reflected in stock price. The result pronounces among stocks/periods of high uncertainty, where information asymmetry heightens.