# 17-002/IV (2017-01-13)

Author(s)
Philip Stork, VU Amsterdam, The Netherlands; Luiz Félix, VU Amsterdam, The Netherlands; Roman Kräussl, University of Luxembourg, Luxembourg
Keywords:
Sentiment, implied volatility skew, equity-risk premium, reversals, predictability.
JEL codes:
G12, G14, G17.

Low probability events are overweighted in the pricing of out-of-the-money index puts and single stock calls. This behavioral bias is strongly time-varying, and is linked to equity market sentiment and higher moments of the risk-neutral density. We _nd that our implied volatility (IV) sentiment measure, jointly derived from index and single stock options, explains investors' overweight of tail events well. When employed within a trading strategy, our IV-sentiment measure delivers economically signi_cant results, which are more consistent than the ones produced by the market sentiment factor. Out-of-sample tests on reversal prediction show that our IV-sentiment measure adds value over and above traditional factors in the equity risk premium
literature.