DEVIATIONS FROM PUT-CALL PARITY AND CONTRARIAN PROFITS

Abstract

Deviations from put-call parity, as well as past stock returns have been shown to contain information about future stock returns. This study aims to combine the forward-looking nature of the volatility spread measure introduced in Cremers and Weinbaum (2010) with other backward-looking measures to create a strategy which provides profitability in excess of the individual measures. In combining both forward-looking volatility spreads and a backward-looking Price to Moving Average ratio, I find that stocks which have relatively expensive calls compared to puts and which have recently traded significantly below their past prices outperform stocks which have relatively expensive puts compared to calls and which have recently traded significantly above their past prices by 67 basis points per week on a similar value-weighted and risk-adjusted basis. I find that better predictability is found using these two measures in stocks with high liquidity and vice versa for stocks with low liquidity. I also find that the volatility spread measure demonstrates higher predictability for negative abnormal returns. Exploring the returns of these contrarian strategies across different market states, I observed seemingly higher profitability in crisis years, and evidence of the degree of predictability does not decrease over the sample period for the combined volatility spread and Price to Moving Average ratio strategy.