Information Content of Right Option Tails : Evidence from S&P 500 Index Options (Preprint)

In this study, we investigate how useful the information content of out-of-the-money S&P 500 index call options is to predict the size and direction of the underlying index for the period 2004-2013. First, we demonstrate that behavior of the right tail of the option implied risk-neutral distribution can be characterized by a single parameter. Subsequently, we find that weekly changes in the tail parameter can be used to devise trading strategies that significantly outperform the underlying index on a risk adjusted basis. Moreover, we demonstrate that even during a period when the strategies do not outperform the index, our approach can be used to obtain information about future index returns. NOTE: This is a preprint. The published version contains significantly more details about the performance of the trading strategies, and it is shown that tail parameter contains forward looking information about the direction of the underlying index. In addition, some minor mistakes have been fixed