Do the Option Prices Forecast Spot Price? Evidence from the KOSPI 200 Index Option Market

This study investigates a forecasting power of volatility curvatures and risk neutral densities implicit in KOSPI 200 option prices by analyzing minute by minute historical index option intraday trading data from January of 2007 to January of 2011. We begin by estimating implied volatility functions and risk neutral price densities based on non-parametric method every minute and by calculating volatility curvature and skewness premium. We then compare the daily rate of return of the signal following trading strategy that we buy (sell) a stock index when the volatility curvature or skewness premium increases (decreases) with that of an intraday buy-and-hold strategy that we buy a stock index on 9:05AM and sell it on 2:50PM. We found that the rate of return of the signal following trading strategy was significantly higher than that of the intraday buy-and-hold strategy, which implies that the option prices have a strong forecasting power on the direction of stock market. Another finding is that the information contents of option prices disappear after three or four minutes.