- Strategy Summary
- 4-Week Holding Period Strategy Update
- 1-Week Holding Period Strategy Update (Target Leverage=1)
- 1-Week Holding Period Strategy Updated (Target Leverage=2)
This is a stylized implementation of the strategy described in the research paper titled "What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?" by Yuhang Xing, Xiaoyan Zhang and Rui Zhao. The authors show that their SKEW factor predicts individual equity returns up to 6 months!
The shape of the volatility smirk has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 10.9% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with the steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to trade out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks. 
Here is the skew measure they use.
My strategy differs in that I arbitrarily chose 1 and 4 week holding periods to study. Additionally this strategy only analyzes a cross-section of ETFs instead of individual stocks. I chose ETFs because liquidity and data quality concerns are minimized. Here are the selected ETFs under analysis.
- Zhang, Xiaoyan and Zhao, Rui and Xing, Yuhang, What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns? (August 14, 2008). AFA 2009 San Francisco Meetings Paper. Available at SSRN:http://ssrn.com/abstract=1107464 or http://dx.doi.org/10.2139/ssrn.1107464