Option market (in)efficiency and implied volatility dynamics after return jumps

TL;DR

This paper investigates how implied volatility in S&P 500 options responds to return jumps, revealing asymmetries and delays that suggest market inefficiencies and implications for arbitrage strategies.

Contribution

It provides empirical evidence of delayed and asymmetric implied volatility adjustments following return jumps, highlighting market inefficiencies in option pricing.

Findings

Implied volatility adjusts gradually after negative return jumps.

Implied volatility from out-of-the-money calls adjusts immediately.

Asymmetric adjustments in implied volatility smile are observed.

Abstract

In informationally efficient financial markets, option prices and this implied volatility should immediately be adjusted to new information that arrives along with a jump in underlying's return, whereas gradual changes in implied volatility would indicate market inefficiency. Using minute-by-minute data on S&P 500 index options, we provide evidence regarding delayed and gradual movements in implied volatility after the arrival of return jumps. These movements are directed and persistent, especially in the case of negative return jumps. Our results are significant when the implied volatilities are extracted from at-the-money options and out-of-the-money puts, while the implied volatility obtained from out-of-the-money calls converges to its new level immediately rather than gradually. Thus, our analysis reveals that the implied volatility smile is adjusted to jumps in underlying's return asymmetrically. Finally, it would be possible to have statistical arbitrage in zero-transaction-cost option markets, but under actual option price spreads, our results do not imply abnormal option returns.