Analysing Implied Volatility Smirk to Predict the US Stock Market Crash During the Global Financial Crisis (GFC)

Tanvir A Bhuiyan

This research analyses the implied volatility smirk (IVS) to predict the US stock market crash during the Global Financial Crisis (GFC). The GFC was significant because all major stock markets experienced substantial losses. Therefore, the likelihood of IVS occurring in GFC condition is very high, as some previous studies documented the evidence of IVS in the stock market crash of 1987. The IVS appears when the out-of-the-money put options implied volatility (OTMPIV) is higher than at-the-money call options implied volatility (ATMCIV). The study conducted empirical analysis in several steps. First, the study obtained the OTMPIV and ATMCIV for the S&P 500 options with one-month, two-month, three-month, four-month, five-month and six-month maturity during the opening, midday, and closing period of a trading day. The difference between the OTMPIV and ATMCIV estimated the IVS. Next, an in-sample test investigated 18 cases (cases 1 to 18) to confirm the development of IVS during GFC (2007-2009). The in-sample analysis also examined another 18 cases (cases 19 to 36) to ensure the absence of the IVS in the post-GFC period (2010-2011). Finally, an out-of-sample test analysed 63 cases (cases 37 to 99) to assess the predictability of IVS for the stock market crash during the GFC. The study reveals a number of critical findings. First, the in-sample test results show that the negative return from simultaneous trading of out-of-the-money put options (OTMP) and at-the-money call options (ATMC) due to OTMPIV is higher than ATMCIV for all 18 cases (cases 1 to 18), confirming the development of IVS during GFC. However, findings of the in-sample test for cases 19 to 36 reveal the positive return from simultaneous trading of OTMP and ATMC because of the lower value of OTMPIV compared to ATMCIV, ensuring no occurrence of IVS in the post-GFC period. Finally, only 13 out of 63 cases (from cases 37 to 99) under the out-of-sample test show the IVS can forecast negative returns in an abnormal stock market. It means the out-of-sample test provides mixed findings and suggests that the predictability of IVS for the US stock market crash depends on the maturity of options, forecast horizon, and options trading period.

Analysing Implied Volatility Smirk to Predict the US Stock Market Crash During the Global Financial Crisis (GFC)

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