Option-implied idiosyncratic skewness and expected returns: Mind the long run

This article examines the time-series predictive ability of the monthly option-implied idiosyncratic skewness (Skew) for the aggregate stock market. We find that Skew is a strong predictor of the U.S. equity premium using both in-sample and out-of-sample tests at forecast horizons up to 36 months over the period from January 1996 to December 2021. In comparison, Skew outperforms the previously used financial and macroeconomic variables. Furthermore, combining information in the transitional predictors with Skew can further improve the forecasting performance than using Skew alone. We provide two explanations for the documented predictability. First, Skew exhibits strong procyclical behavior and consistently declines ahead of economic downturns. Second, Skew acts as a forward-looking signal of investor sentiment and disagreement—positive shocks to Skew significantly increase both future investor sentiment and disagreement, with effects that persist over several horizons.