Why Does Options Market Information Predict Stock Returns?

Several influential studies show that transformations of implied volatilities calculated from options prices predict stock returns. This predictability is puzzling because market participants can readily observe options prices. We find that this predictability is consistent with implied volatilities reflecting stock borrow fees that are known to predict stock returns. We derive a formula relating the option-implied volatility spread to the borrow fee. Motivated by this relation, we show that the return predictability from the option signals decreases by about two-thirds if high-fee stocks are excluded. The predictability decreases by a similar amount after stock returns are adjusted for borrow fees.