This paper examines the source of the predictive power of option-implied skewness (OIS) for future stock returns. Given that informed investors prefer to trade in the options market and it takes time for the information contained in the option prices to get incorporated into stock prices, OIS can predict future stock returns. We hypothesize that the predictive power of OIS stems from a delayed response of stock prices to information observable in the options market, and document evidence in support. In particular, we find that the relation between OIS and future stock returns is stronger among stocks that are more costly to shortsell. Higher shorting costs are presumed to deter stock prices from reflecting the information embedded in OIS, resulting in a stronger positive relation between OIS and stock returns. Moreover, we reveal that the predictive power of OIS is more prominent and persistent during high-sentiment periods. It also supports that stock mispricing is associated with the positive OIS-return relation, considering that high sentiment produces overpricing
more so than low sentiment produces underpricing.
Keywords: skewness, investor sentiment, limit-to-arbitrage, shorting costs
