January 17, 2014
We propose a measure of dispersion in options traders’ expectations about future stock returns by using dispersion in trading volume across strike prices. We find that an increased dispersion in expectations forecasts lower subsequent excess market returns at both short and long horizons. Trading strategies based on the dispersion measure reveal significant utility gains for a mean-variance investor as compared to a buy-hold strategy. Further, the dispersion measure exhibits additional predictive power when combined with the variance risk premium, thus showing that the two variables capture different aspects of the variation in returns.