A New Index of Option Implied Absolute Deviation

Abstract

This paper proposes a new index of forward looking absolute deviation extracted from option prices. The new index, named absolute deviation index (ADIX), is model-free and easy to compute using at-the-money call and put option prices. It is shown that the spread between volatility index (VIX) and ADIX captures departures from normality in the risk-neutral distribution and an empirical analysis using S&P 500 options data for the time period 1996–2021 reveals that the spread carries significant forecasting ability with respect to future equity returns at short to medium horizons. Portfolio strategies that use the spread as a predictor of S&P 500 returns outperform buy-and-hold strategies in an out-of-sample mean-variance asset allocation exercise.