Market Expectations And Probability Distributions Implicit In Option Prices

Abstract

This paper investigates whether specific characteristics of the returns distributions implied by options prices constitute useful information for the purpose of predicting changes in market direction. The key distributional characteristics we focus on are skewness, kurtosis, and the probability weight in the extreme tails of the implied distributions. We present a new methodology for extracting the returns distributions and apply it to S&P 500 index futures-options prices for twenty days surrounding the four largest market reversals in calendar 2001.