Abnormal Volatility and Stock Returns
Standardized abnormal volatility captures an individual stock’s implied volatility which is not explained by its estimated relationship with the level of the VIX Index. I have shown by simulation that this measure can detect shocks to volatility. While shocks may be temporary or indicate lasting shifts in a stock’s risk structure, they may predict future stock portfolio returns.
To explore the potential investment value in abnormal volatility, I create an abnormal volatility factor. This factor tracks the monthly return of a strategy that essentially is long stocks with high abnormal volatility and short stocks with low abnormal volatility. This strategy generates significant returns not explained by common risk factors. A monthly zero-investment portfolio generates 0.60% (7.49% annualized) alpha relative to the Fama and French five-factor model.
Returns to a short-term reversal strategy is most closely related to the abnormal volatility strategy as stocks with high abnormal volatility tend to have low returns in the month leading up to portfolio formation. However, the short-term reversal strategy can not explain its alpha.