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The Information in Option Volume for Stock Prices Jun Pan MI   T Sloan School of Management Allen M. Poteshman University ...
Derivatives in Financial Markets <ul><li>The traditional view of derivatives:  redundant via dynamic trading of the underl...
Why Trade Derivatives? <ul><li>Risk sharing, in an otherwise incomplete market [Ross 1976]: </li></ul><ul><ul><li>Multiple...
“ Fact and Fantasy in the Use of Options”  (Fischer Black, 1975) <ul><li>“ Since an investor can usually get more action f...
Return to 1 month ATM call as a function of return to stock
Informed Option Trading:  Mixed Empirical Evidence <ul><li>Option volume contains information before important firm specif...
Main Empirical Finding <ul><li>Clear evidence that option volume in general does contain information about future stock pr...
Option Dataset <ul><li>Daily records of CBOE trading volume for all CBOE listed options from January 1990 through December...
Trade Types <ul><li>Each option transaction is identified as: </li></ul><ul><ul><li>Open buy:  buyer initiated to open a n...
Investor Classes <ul><li>The volume data is further categorized according to which of the following four investor classes ...
Table 1:  Option trading volume by trade type and investor class
Information in Open Buy Volume <ul><li>Trades initiated by buyers to open new positions </li></ul><ul><li>Build daily cros...
Table 3:  Open Buy Volume Results Following Portfolio Formation
Open Buy Volume Findings <ul><li>Average stock returns decrease with increasing PC-ranking for at least 5 days after portf...
Table 3:  Open Buy Volume Results Leading up to Portfolio Formation
Table 5:  Open Buy Volume by Year
Closing Time Differences <ul><li>The CBOE closes after the underlying stock market. </li></ul><ul><li>Part of day +1 retur...
Temporary Price Pressure <ul><li>Suppose market makers delta-hedge and non-market makers do not. </li></ul><ul><li>Then a ...
Results by Firm Size <ul><li>Sort cross-section of stocks into small, medium, and large groups. </li></ul><ul><li>Average ...
Table 6:  Open Buy Volume by Firm Size
Results by Investor Class <ul><li>Four investor classes </li></ul><ul><ul><li>Firm proprietary traders </li></ul></ul><ul>...
Table 6:  Results by Investor Type
Relationship to Known Cross-Sectional Relations <ul><li>Run daily cross-sectional regressions with + n  day stock return o...
Table 7:  Daily Cross-Sectional Regressions [T-Statistics]
Information in Aggregate Volume <ul><li>General public sees only total option volume, not option volume broken down by tra...
Table 8:  Results for Publicly Observable Volume
Table 8:  Results by Volume Type
Information in Index Option Trading <ul><li>Also examined the information content of option trading on three broad market ...
Work in Progress <ul><li>Is there information for future stock prices in publicly observable option market data? </li></ul...
Conclusion <ul><li>We produce strong evidence that option volume contains information about the future movements of underl...
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The Information in Option Volume for Stock Prices

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Transcript of "The Information in Option Volume for Stock Prices"

  1. 1. The Information in Option Volume for Stock Prices Jun Pan MI T Sloan School of Management Allen M. Poteshman University of Illinois at Urbana-Champaign
  2. 2. Derivatives in Financial Markets <ul><li>The traditional view of derivatives: redundant via dynamic trading of the underlying security. </li></ul><ul><li>Empirical evidence: not completely redundant. </li></ul>
  3. 3. Why Trade Derivatives? <ul><li>Risk sharing, in an otherwise incomplete market [Ross 1976]: </li></ul><ul><ul><li>Multiple risk factors [Bates (2002), Liu and Pan (2002)] </li></ul></ul><ul><ul><li>Dynamic trading not allowed [Haugh and Lo (2001)] </li></ul></ul><ul><ul><li>Other market frictions: short-sale constraints [Basak and Croitoru (2000)], non-hedgeable background risk [Franke, Stapleton, and Subrahmanyam (1998)] </li></ul></ul><ul><li>Differences of Opinion [Kraus and Smith (1996), Bates (2002), Buraschi and Jiltsov (2002)] </li></ul><ul><li>Information Trading [Black (1975), Back (1993), Easley, O’Hara, and Srinivas (1998)] </li></ul>
  4. 4. “ Fact and Fantasy in the Use of Options” (Fischer Black, 1975) <ul><li>“ Since an investor can usually get more action for a given investment in options than he can by investing directly in the underlying stock, he may choose to deal in options when he feels he has an especially important piece of information. </li></ul><ul><li>Also, it is easier to take a short position by writing options than by shorting the underlying stock… </li></ul><ul><li>And many potential information traders will trade on the options market when they wouldn’t bother to trade at all if the options market did not exist.” </li></ul>
  5. 5. Return to 1 month ATM call as a function of return to stock
  6. 6. Informed Option Trading: Mixed Empirical Evidence <ul><li>Option volume contains information before important firm specific news </li></ul><ul><ul><li>Earnings announcements [Amin and Lee (1997)] </li></ul></ul><ul><ul><li>Takeover annnouncements [Cao, Chen, and Griffin (2002)] </li></ul></ul><ul><li>During “normal” times, stock volume not option volume predicts underlying stock returns </li></ul><ul><ul><li>Daily intervals [Cao, Chen, and Griffin (2002)] </li></ul></ul><ul><ul><li>Intraday [Chan, Chung, and Fong (2002)] </li></ul></ul><ul><li>Easley, O’Hara, and Srnivas (1998) find information in option volume for contemporaneous stock price movements. Weaker intraday evidence that option volume contains information for future stock prices … but the sign tends to be backwards </li></ul>
  7. 7. Main Empirical Finding <ul><li>Clear evidence that option volume in general does contain information about future stock price movements </li></ul><ul><li>Put/call ratios constructed from equity option volume are significant predictors of cross-sectional stock returns for at least one week into the future </li></ul>
  8. 8. Option Dataset <ul><li>Daily records of CBOE trading volume for all CBOE listed options from January 1990 through December 2001 </li></ul><ul><li>Each option is identified by its underlying stock or index, as a put or a call, and by its strike price and time to expiration </li></ul><ul><li>A unique feature of our dataset is that the daily trading volume for each option is broken down into 16 categories defined by 4 trade types and 4 investor classes </li></ul>
  9. 9. Trade Types <ul><li>Each option transaction is identified as: </li></ul><ul><ul><li>Open buy: buyer initiated to open a new position </li></ul></ul><ul><ul><li>Open sell: seller initiated to open a new position </li></ul></ul><ul><ul><li>Close buy: buyer initiated to close an existing short position </li></ul></ul><ul><ul><li>Close sell: seller initiated to close an existing long position </li></ul></ul><ul><li>We know with certainty the “sign” of the trading volume. By contrast, previous studies infer the sign, with some error, from quote and trade data. </li></ul><ul><li>We know whether the initiator of observed volume is opening a new position or closing an existing one. None of the previous studies have had this information available. </li></ul>
  10. 10. Investor Classes <ul><li>The volume data is further categorized according to which of the following four investor classes initiates the trades: </li></ul><ul><ul><li>Firm proprietary traders </li></ul></ul><ul><ul><li>Public customers of discount brokers </li></ul></ul><ul><ul><li>Public customers of full-service brokers </li></ul></ul><ul><ul><li>Other public customers </li></ul></ul><ul><li>Trades initiated by market makers are not recorded in our data. </li></ul>
  11. 11. Table 1: Option trading volume by trade type and investor class
  12. 12. Information in Open Buy Volume <ul><li>Trades initiated by buyers to open new positions </li></ul><ul><li>Build daily cross-sections of stocks with liquid option trading – at least 50 contracts </li></ul><ul><li>On each day sort stocks into quintiles based on </li></ul><ul><li>If investors with bad news buy new puts and investors with good news buy new calls, then high open buy put/call ratio stock portfolios should subsequently underperform low put/call ratio stock portfolios </li></ul>
  13. 13. Table 3: Open Buy Volume Results Following Portfolio Formation
  14. 14. Open Buy Volume Findings <ul><li>Average stock returns decrease with increasing PC-ranking for at least 5 days after portfolio formation. </li></ul><ul><li>The average next day returns for highest and lowest PC portfolios are –14.6 bps and 25 bps, respectively. </li></ul><ul><ul><li>CRSP value-weighted return generates an average daily return of 5 bps over the same period </li></ul></ul><ul><li>A hedge portfolio that buys low PC quintile and sell high PC quintile generates 40 bps over the next day and 1% over the next week. Return comes about equally from long and short positions. </li></ul>
  15. 15. Table 3: Open Buy Volume Results Leading up to Portfolio Formation
  16. 16. Table 5: Open Buy Volume by Year
  17. 17. Closing Time Differences <ul><li>The CBOE closes after the underlying stock market. </li></ul><ul><li>Part of day +1 return may reflect information released on day 0 after stock market closes but before option market closes </li></ul><ul><li>On June 23, 1997, CBOE changed the closing time for equity options from 4:10 PM (EST) to 4:02 PM (EST). </li></ul><ul><li>If an important part of day +1 return results from closing time difference, the day +1 return should decline significantly after June 1997. This is not observed. </li></ul>
  18. 18. Temporary Price Pressure <ul><li>Suppose market makers delta-hedge and non-market makers do not. </li></ul><ul><li>Then a buyer initiated call transaction will result in market maker selling a call and hedging by buying delta shares. </li></ul><ul><li>So, open buy call may result in upward price pressure on underlying stock even if the buyer of the call has no fundamental information. </li></ul><ul><li>Temporary price pressure is not a promising alternative explanation </li></ul><ul><ul><li>Price pressure would occur on day 0 </li></ul></ul><ul><ul><li>There would be a price reversal </li></ul></ul>
  19. 19. Results by Firm Size <ul><li>Sort cross-section of stocks into small, medium, and large groups. </li></ul><ul><li>Average NYSE deciles are, respectively, 4.3, 7.8, and 9.8. </li></ul><ul><li>Significant information in option volume for each size group </li></ul><ul><li>Predictability is stronger for smaller stocks which is consistent with information flow for large stocks typically being more efficient </li></ul>
  20. 20. Table 6: Open Buy Volume by Firm Size
  21. 21. Results by Investor Class <ul><li>Four investor classes </li></ul><ul><ul><li>Firm proprietary traders </li></ul></ul><ul><ul><li>Customers of discount brokers </li></ul></ul><ul><ul><li>Customers of full-service brokers </li></ul></ul><ul><ul><li>Other public customers </li></ul></ul><ul><li>Results speak directly to the issue of whose option volume is informative – not to the issue of who is more informed. </li></ul>
  22. 22. Table 6: Results by Investor Type
  23. 23. Relationship to Known Cross-Sectional Relations <ul><li>Run daily cross-sectional regressions with + n day stock return on </li></ul><ul><ul><li>Open buy put-call ratio </li></ul></ul><ul><ul><li>Size </li></ul></ul><ul><ul><li>NYSE BM decile </li></ul></ul><ul><ul><li>Momentum decile </li></ul></ul><ul><ul><li>Past week return </li></ul></ul><ul><ul><li>Analyst coverage </li></ul></ul><ul><ul><li>Ratio of option volume to und. stock volume </li></ul></ul><ul><li>Cross-sectional predictability is robust to these known cross-sectional relations. </li></ul>
  24. 24. Table 7: Daily Cross-Sectional Regressions [T-Statistics]
  25. 25. Information in Aggregate Volume <ul><li>General public sees only total option volume, not option volume broken down by trade type. </li></ul><ul><li>We aggregate option volume across four trade types to obtain a close proxy to publicly observable total option volume. </li></ul><ul><li>There is still significant predictability, but its magnitude and duration are much less than for open buy volume. </li></ul><ul><li>Similar results when we construct actual CBOE trading volume from trade data in Berkeley Option Data Base (1/1987-12/1996) </li></ul>
  26. 26. Table 8: Results for Publicly Observable Volume
  27. 27. Table 8: Results by Volume Type
  28. 28. Information in Index Option Trading <ul><li>Also examined the information content of option trading on three broad market indices: S&P 100 (OEX), S&P 500 (SPX), and Nasdaq-100 (NDX) </li></ul><ul><li>Investigating whether option market investors possess information about future price moves of stock market as a whole </li></ul><ul><li>No evidence of informed trading in index options </li></ul>
  29. 29. Work in Progress <ul><li>Is there information for future stock prices in publicly observable option market data? </li></ul><ul><li>Can the information in publicly observable option market data for future stock prices be traded on profitably in the presence of bid-ask spreads, commissions, etc. </li></ul>
  30. 30. Conclusion <ul><li>We produce strong evidence that option volume contains information about the future movements of underlying stock prices </li></ul><ul><li>The predictability stretches a week into the future and is strongest for small stocks </li></ul><ul><li>Option trading of customers of full-service brokers is most informative </li></ul><ul><li>We do not find any evidence of informed trading in the index option market </li></ul><ul><li>Work in progress examines profitably of strategies that trade in the stock market based upon publicly observable option market data </li></ul>
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