Option Market Activity and Behavioral Finance Josef Lakonishok Inmoo Lee Allen M. Poteshman
How Do Investors Use Options? <ul><li>Over last three decades much work on pricing and hedging stock options </li></ul><ul...
This paper <ul><li>Establish some key facts about option market activity </li></ul><ul><ul><li>In general </li></ul></ul><...
Unique Dataset to Establish Facts <ul><li>Detailed daily open interest and volume information for all CBOE listed options ...
Our Approach <ul><li>For different types of investors and categories of stocks get daily average </li></ul><ul><ul><li>Lon...
Results 1:  Option Market Activity Levels <ul><li>Fact :  Non-market makers have about four times more long call than long...
Results 2:  Cross-Sectional Determinants of Option Activity <ul><li>Fact :  All types of non-market makers buy more calls ...
Results 3:  Option Market Activity During the Bubble <ul><li>Fact :  Unsophisticated investors significantly increased buy...
Outline <ul><li>Data </li></ul><ul><li>Option market activity levels </li></ul><ul><li>Cross-sectional determinants of opt...
Data <ul><li>Daily data on all CBOE listed options from Jan 1990 through Dec 2001 </li></ul><ul><li>Three investor classes...
Levels of Investor Sophistication <ul><li>Most sophisticated:  Firm proprietary traders  (Poteshman and Serbin (2003)) </l...
Measuring Option Market Activity <ul><li>Measure option open interest or volume on a trade date ( t ), underlying stock ( ...
Table 1:  Avg. Daily Open Interest as % of Shares Outstanding <ul><li>Average aggregate open interest is 0.56% of shares o...
Table 1:  Avg. Daily Open Interest as % of Shares Outstanding
Profit to Covered Call S Current (OTM)
Levels of Open Interest <ul><li>Across the investor classes open interest for long calls is about four times greater than ...
Levels of Open Interest (Cont.) <ul><li>More short than long call open interest </li></ul><ul><ul><li>On surface contradic...
Table 2:  Avg. Daily Open Volume as % of Shares Outstanding
Table 2:  Avg. Daily Open Volume as % of Shares Outstanding
Table 2:  Avg. Turnover Time (in Trade Dates)
Levels of Option Volume <ul><li>For both calls and puts there is more open buys than open sells for all investor classes. ...
Cross-Sectional Determinants <ul><li>Dependent variables:  Open buy call volume, open sell call volume, open buy put volum...
Table III:  Large Stock Regressions
Table III:  Large Stock Regressions
Table III:  Large Stock Regressions
Table IV:  Impact of One Standard Deviation Shock
Table IV:  Impact of One Standard Deviation Shock
Table IV:  Impact of One Standard Deviation Shock
Open Buy Call Volume <ul><li>Discount and full-service customers have significantly positive coef. on the return variables...
Open Sell Call Volume <ul><li>Full-service customers have positive and significant coefficients on past returns variables....
Open Buy Put Volume <ul><li>Discount customers:  Buy more (fewer) new puts on underlying stocks that have increased (decre...
Open Sell Put Volume <ul><li>There is more selling than buying of puts </li></ul><ul><li>For discount and full-service inv...
Option Market Activity During the Bubble <ul><li>Compare option market activity of the various investor classes before dur...
Fig. 2:  Price/Book of Russell 1000 Growth Divided by Price/Book of Value
Table V: Avg. Daily Open Volume as % of Shares Outstanding (Large Stocks)
Table V: Avg. Daily Open Volume as % of Shares Outstanding (Large Stocks)
Open Buy Call Volume <ul><li>Discount customers </li></ul><ul><ul><li>Doubles from pre-bubble to beginning of bubble </li>...
Open Buy Put Volume <ul><li>Well-known that it can be difficult to establish short positions in the stock market </li></ul...
Table VI:  Large Stock Open Buy Call Volume Regr. for Discount Customers
Table VI:  Large Stock Open Buy Call Volume Regr. for Full-Service Customers
Table VII: Impact on Open Buy Call Volume of One Std. Dev. Shock
Open Buy Call Volume Across the Subperiods <ul><li>Over the whole period there is trend-chasing, but the results are not c...
Open Buy Call Volume Across the Subperiods:  Full-service <ul><li>Table V (looking at open buy call volume unconditionally...
Table IX:  Growth/Value Stock Average Daily Open Buy Call Vol.
Table IX:  Growth/Value Stock Average Daily Open Buy Put Vol.
Value Versus Growth:  Discount Customers <ul><li>Buying calls is the most important activity for all subperiods </li></ul>...
Value Versus Growth:  Full-Service/Firm Proprietary <ul><li>Mild increase in open buy call activity on underlying growth s...
Table X:  Open Buy Call Volume Regressions, 1998-3/2000
Table XI:  Percent Impact of One Standard Deviation Shock
Cross-Sectional Determinants of Open Buy Call Volume During the Bubble <ul><li>Discount:  One standard deviation shock to ...
Conclusion <ul><li>Long put positions are relatively unimportant:  Only ¼ of long call positions and did not increase duri...
Conclusion -- Continued <ul><li>Short put positions are more prevalent than long put positions – especially so on value st...
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Option Market Activity and Behavioral Finance

  1. 1. Option Market Activity and Behavioral Finance Josef Lakonishok Inmoo Lee Allen M. Poteshman
  2. 2. How Do Investors Use Options? <ul><li>Over last three decades much work on pricing and hedging stock options </li></ul><ul><li>Little is known about how investors actually employ stock options </li></ul><ul><ul><li>What are the levels of long and short open interest and trading volume by different types of investors? </li></ul></ul><ul><ul><li>What are the cross-sectional determinants of option activity? </li></ul></ul><ul><ul><li>How did option market activity change during the bubble of the late 1990s and early 2000? </li></ul></ul>
  3. 3. This paper <ul><li>Establish some key facts about option market activity </li></ul><ul><ul><li>In general </li></ul></ul><ul><ul><li>During the bubble </li></ul></ul><ul><li>Offer conjectures about the facts based upon </li></ul><ul><ul><li>Discussions with option market participants </li></ul></ul><ul><ul><li>Behavioral finance literature </li></ul></ul>
  4. 4. Unique Dataset to Establish Facts <ul><li>Detailed daily open interest and volume information for all CBOE listed options from 1990 through 2001 </li></ul><ul><li>All data broken down by different types of investors </li></ul><ul><li>Open interest: long and short </li></ul><ul><li>Volume: buyer/seller initiated and open/close option positions </li></ul><ul><li>Limitation: Cannot see combined trades </li></ul>
  5. 5. Our Approach <ul><li>For different types of investors and categories of stocks get daily average </li></ul><ul><ul><li>Long and short, put and call open interest </li></ul></ul><ul><ul><li>Call and put buys and sells to open new positions </li></ul></ul><ul><li>Regress four volume categories on stock returns over various past horizons </li></ul><ul><li>Do analyses over entire 1990-2001 period and for subperiods </li></ul>
  6. 6. Results 1: Option Market Activity Levels <ul><li>Fact : Non-market makers have about four times more long call than long put open interest </li></ul><ul><ul><li>Comment : Surprising because harder to short stocks </li></ul></ul><ul><ul><li>Conjecture : Analysts make pos. recs. Easier to manage calls </li></ul></ul><ul><li>Fact : Non-market makers have more short than long call open interest </li></ul><ul><ul><li>Conjecture : Much of the short call open interest is part of covered call positions. Compared to holding stock long, covered calls lose in fewer states of the world and the losses are less severe. Consistent with loss aversion and narrow framing </li></ul></ul><ul><li>Fact : Non-market makers have more short than long put open interest </li></ul><ul><ul><li>Conjecture : Puts are sold on stocks viewed as undervalued. If stock increases just keep the premium, if it decreases buy the stock at an even lower price </li></ul></ul><ul><ul><li>Corroboration : More short put open interest is observed on value than growth stocks </li></ul></ul>
  7. 7. Results 2: Cross-Sectional Determinants of Option Activity <ul><li>Fact : All types of non-market makers buy more calls to open new positions after high past returns (extending up to two years in the past) </li></ul><ul><ul><li>Conjecture : Option market participants are trend-chasers, and sentiment about stocks is established over long horizons </li></ul></ul><ul><li>Fact : More calls are also sold after high past returns </li></ul><ul><ul><li>Conjecture : This also represents trend-chasing because the short calls are part of covered call positions which are viewed as conservative long positions </li></ul></ul><ul><li>Fact : More puts are sold to open new positions when past returns on underlying stock are low over past quarter </li></ul><ul><ul><li>Conjecture : Contrarian investors like to sell puts on beaten down stocks </li></ul></ul>
  8. 8. Results 3: Option Market Activity During the Bubble <ul><li>Fact : Unsophisticated investors significantly increased buying of calls on growth but not value stocks during the bubble </li></ul><ul><li>Fact : Sophisticated investors did not increase their call buying during the bubble </li></ul><ul><li>Fact : None of the investor types increased their put buying during the bubble </li></ul><ul><ul><li>No evidence that investors used the option market during the bubble to overcome short-sales constraints (compare to Ofek and Richardson (2003)) </li></ul></ul>
  9. 9. Outline <ul><li>Data </li></ul><ul><li>Option market activity levels </li></ul><ul><li>Cross-sectional determinants of option market activity </li></ul><ul><li>Option market activity during the bubble </li></ul><ul><li>Conclusion </li></ul>
  10. 10. Data <ul><li>Daily data on all CBOE listed options from Jan 1990 through Dec 2001 </li></ul><ul><li>Three investor classes: firm proprietary, discount, full-service </li></ul><ul><li>Open interest: long and short for each investor class </li></ul><ul><li>Volume: buyer/seller initiated and opening/closing option position (also for each investor class) </li></ul><ul><li>CRSP/COMPUSTAT: stock returns, shares outstanding, BM ratios </li></ul>
  11. 11. Levels of Investor Sophistication <ul><li>Most sophisticated: Firm proprietary traders (Poteshman and Serbin (2003)) </li></ul><ul><li>Intermediate sophistication: Full-service customers </li></ul><ul><ul><li>Includes hedge funds </li></ul></ul><ul><ul><li>Mahani and Poteshman (2003) </li></ul></ul><ul><ul><li>Pan and Poteshman (2003) </li></ul></ul><ul><li>Least sophisticated: Discount customers </li></ul><ul><ul><li>Odean (1998), Odean and Barber (2000) </li></ul></ul><ul><ul><li>Mahani and Poteshman (2003) </li></ul></ul><ul><ul><li>Pan and Poteshman (2003) </li></ul></ul>
  12. 12. Measuring Option Market Activity <ul><li>Measure option open interest or volume on a trade date ( t ), underlying stock ( s ), investor class ( i ), and type of open interest ( k ): </li></ul><ul><li>Similarly for OptionVolPercentageShares </li></ul>
  13. 13. Table 1: Avg. Daily Open Interest as % of Shares Outstanding <ul><li>Average aggregate open interest is 0.56% of shares outstanding  Turnover 6%/year </li></ul>
  14. 14. Table 1: Avg. Daily Open Interest as % of Shares Outstanding
  15. 15. Profit to Covered Call S Current (OTM)
  16. 16. Levels of Open Interest <ul><li>Across the investor classes open interest for long calls is about four times greater than for long puts </li></ul><ul><ul><li>Somewhat surprising because it is more costly and difficult to go short than long in the stock market but not in the option market </li></ul></ul><ul><ul><li>On the other hand: financial advisers push long stock positions, long calls are easier to manage </li></ul></ul>
  17. 17. Levels of Open Interest (Cont.) <ul><li>More short than long call open interest </li></ul><ul><ul><li>On surface contradicts idea that investors are relatively averse to short positions </li></ul></ul><ul><ul><li>But many short calls are part of covered call positions </li></ul></ul><ul><ul><ul><li>Heavily promoted as a conservative long position </li></ul></ul></ul><ul><ul><ul><li>Consistent with loss aversion and mental accounting </li></ul></ul></ul><ul><li>For discount and full-service more short put than long put open interest </li></ul><ul><li>Over entire 1990-2001 time period there are no major differences across different types of underlying stocks </li></ul><ul><ul><li>Largest difference: Full-service customers have more short put open interest on value than growth </li></ul></ul>
  18. 18. Table 2: Avg. Daily Open Volume as % of Shares Outstanding
  19. 19. Table 2: Avg. Daily Open Volume as % of Shares Outstanding
  20. 20. Table 2: Avg. Turnover Time (in Trade Dates)
  21. 21. Levels of Option Volume <ul><li>For both calls and puts there is more open buys than open sells for all investor classes. </li></ul><ul><li>Since there is more short than long call open interest for full-service customers, they must hold short call positions longer than long call positions </li></ul><ul><ul><li>Short call positions are held for an average of 56 days </li></ul></ul><ul><ul><li>Long call positions are held for an average of 33 days </li></ul></ul><ul><ul><li>Suggests full-service (and discount) customers use short calls in longer-term investment strategies </li></ul></ul>
  22. 22. Cross-Sectional Determinants <ul><li>Dependent variables: Open buy call volume, open sell call volume, open buy put volume, open sell put volume. </li></ul><ul><li>Explanatory variables: Returns on the underlying stock over the past week, month, quarter, year, and two years </li></ul><ul><li>Controls: BM ratio and volatility of underlying stock </li></ul><ul><li>Report time-series averages of the intercept and slopes from daily cross-sectional regressions </li></ul>
  23. 23. Table III: Large Stock Regressions
  24. 24. Table III: Large Stock Regressions
  25. 25. Table III: Large Stock Regressions
  26. 26. Table IV: Impact of One Standard Deviation Shock
  27. 27. Table IV: Impact of One Standard Deviation Shock
  28. 28. Table IV: Impact of One Standard Deviation Shock
  29. 29. Open Buy Call Volume <ul><li>Discount and full-service customers have significantly positive coef. on the return variables for all past horizons </li></ul><ul><ul><li>Trend-chasing: Daily data, option contracts can be created and destroyed at will </li></ul></ul><ul><ul><li>Sentiment developed over extended periods impacts investment decisions </li></ul></ul><ul><li>The impact of past returns is economically large </li></ul><ul><ul><li>One standard deviation shock to past return variables increases daily open buy call volume for discount and full-service by 78% and 57%, respectively. </li></ul></ul>
  30. 30. Open Sell Call Volume <ul><li>Full-service customers have positive and significant coefficients on past returns variables. One standard deviation shock increases vol. by 63% </li></ul><ul><ul><li>Most of volume is from writing covered calls </li></ul></ul><ul><ul><li>Conservative, income enhancing strategy </li></ul></ul><ul><ul><li>Prospect theory maintains that investors are more likely to write calls on their stocks with gains than losses </li></ul></ul><ul><li>Less wealthy discount customers are less likely to own underlying stock and the impact of past returns is less clear </li></ul>
  31. 31. Open Buy Put Volume <ul><li>Discount customers: Buy more (fewer) new puts on underlying stocks that have increased (decreased) in price </li></ul><ul><ul><li>Expected from prospect theory: Investors are locking in gains </li></ul></ul><ul><ul><li>Contrarian investing </li></ul></ul><ul><li>Full-service customers: Similar to discount, but clear effect is limited to returns more than three months in past </li></ul><ul><li>Since buying puts is not a popular activity, the average option market investor is a trend-chaser (from open buy call regressions) </li></ul>
  32. 32. Open Sell Put Volume <ul><li>There is more selling than buying of puts </li></ul><ul><li>For discount and full-service investors the coefficients on past returns are negative over the last quarter and positive over longer horizons </li></ul><ul><ul><li>Suggests investors believe weakness in stock is temporary </li></ul></ul><ul><ul><li>Investors sell puts thinking that if stock price increases they will just keep premium while if it decreases they are happy to buy the stock at the strike price </li></ul></ul>
  33. 33. Option Market Activity During the Bubble <ul><li>Compare option market activity of the various investor classes before during and after the bubble </li></ul><ul><li>Define </li></ul><ul><ul><li>Pre-bubble  1990 - 1994 </li></ul></ul><ul><ul><li>Beginning of bubble  1995 - 1997 </li></ul></ul><ul><ul><li>Height of bubble  1998 - March 2000 </li></ul></ul><ul><ul><li>Post-bubble  April 2000 - 2001 </li></ul></ul>
  34. 34. Fig. 2: Price/Book of Russell 1000 Growth Divided by Price/Book of Value
  35. 35. Table V: Avg. Daily Open Volume as % of Shares Outstanding (Large Stocks)
  36. 36. Table V: Avg. Daily Open Volume as % of Shares Outstanding (Large Stocks)
  37. 37. Open Buy Call Volume <ul><li>Discount customers </li></ul><ul><ul><li>Doubles from pre-bubble to beginning of bubble </li></ul></ul><ul><ul><li>Increases another 50% at height of bubble </li></ul></ul><ul><ul><li>Declines by a factor of three post-bubble </li></ul></ul><ul><ul><li>Increased other open volume as well, but during height of bubble 56% was buying calls </li></ul></ul><ul><li>Full-service customers </li></ul><ul><ul><li>Stable from pre-bubble to beginning of bubble </li></ul></ul><ul><ul><li>Decreases a bit during height of bubble </li></ul></ul><ul><ul><li>Cut in half in post-bubble period </li></ul></ul><ul><li>Firm proprietary traders </li></ul><ul><ul><li>The bubble is a non-event </li></ul></ul>
  38. 38. Open Buy Put Volume <ul><li>Well-known that it can be difficult to establish short positions in the stock market </li></ul><ul><li>Ofek and Richardson (2003) suggest that short-sales constraints were an important contributor to the bubble </li></ul><ul><li>But, we see no major increase in open buy put volume during the bubble </li></ul><ul><li>Apparently, during a bubble it is not easy to be contrarian </li></ul>
  39. 39. Table VI: Large Stock Open Buy Call Volume Regr. for Discount Customers
  40. 40. Table VI: Large Stock Open Buy Call Volume Regr. for Full-Service Customers
  41. 41. Table VII: Impact on Open Buy Call Volume of One Std. Dev. Shock
  42. 42. Open Buy Call Volume Across the Subperiods <ul><li>Over the whole period there is trend-chasing, but the results are not consistent across the subperiods </li></ul><ul><li>The height of the bubble period definitely stands out </li></ul><ul><ul><li>Coefficients on past returns are all positive and highly significant </li></ul></ul><ul><ul><li>For discount customers a one standard deviation shock to return variables increases open buy call volume by 154% </li></ul></ul><ul><ul><li>Longer term past returns are especially important </li></ul></ul><ul><ul><li>Suggests least-sophisticated investors contributed to run-up in prices of stocks that did well in the past </li></ul></ul>
  43. 43. Open Buy Call Volume Across the Subperiods: Full-service <ul><li>Table V (looking at open buy call volume unconditionally) makes it look like they did not increase their positive speculation during the bubble </li></ul><ul><li>Tables VI and VII show that they did not escape the frenzy </li></ul><ul><li>During the height of the bubble they chased better performing stocks </li></ul><ul><li>Post-bubble there is a dramatic change in behavior for both full-service and discount </li></ul><ul><ul><li>Contrarian with respect to short-horizon past returns </li></ul></ul><ul><ul><li>Impact of longer horizon past returns is much more muted </li></ul></ul>
  44. 44. Table IX: Growth/Value Stock Average Daily Open Buy Call Vol.
  45. 45. Table IX: Growth/Value Stock Average Daily Open Buy Put Vol.
  46. 46. Value Versus Growth: Discount Customers <ul><li>Buying calls is the most important activity for all subperiods </li></ul><ul><li>Growth Stock Open Buy Call Volume </li></ul><ul><ul><li>Doubles from pre-bubble to beginning of bubble </li></ul></ul><ul><ul><li>Doubles again at height of bubble </li></ul></ul><ul><ul><li>Declines by a factor of four post-bubble </li></ul></ul><ul><li>Value stocks: Did not increase volume that opens new calls </li></ul><ul><li>Thus, option market evidence is that during height of bubble discount customers dramatically increased their speculation that growth stock prices would rise but did not increase speculation that value stock prices would rise </li></ul>
  47. 47. Value Versus Growth: Full-Service/Firm Proprietary <ul><li>Mild increase in open buy call activity on underlying growth stocks during the bubble </li></ul><ul><li>A reduction in open buy call activity on underlying value stocks during the bubble </li></ul><ul><li>For firm proprietary traders the bubble period is a non-event in terms of their option activity </li></ul>
  48. 48. Table X: Open Buy Call Volume Regressions, 1998-3/2000
  49. 49. Table XI: Percent Impact of One Standard Deviation Shock
  50. 50. Cross-Sectional Determinants of Open Buy Call Volume During the Bubble <ul><li>Discount: One standard deviation shock to past return variables results in a 211% increase in open buy call volume on growth stocks and 50% increase on value stocks </li></ul><ul><li>Full-Service: 109% for growth stocks and 51% for value stocks </li></ul><ul><li>There was substantial trend-chasing across the board during the bubble, but it was most intense for </li></ul><ul><ul><li>Growth stocks </li></ul></ul><ul><ul><li>Customers of discount brokers </li></ul></ul>
  51. 51. Conclusion <ul><li>Long put positions are relatively unimportant: Only ¼ of long call positions and did not increase during the bubble period </li></ul><ul><li>Short call positions are more prevalent than long call positions among non-market makers </li></ul><ul><ul><li>Covered-calls result in losses in fewer states of the world than stock positions and only give a lower payoff than stock alone when the stock has increased in price </li></ul></ul><ul><ul><li>Consistent with loss aversion and narrow framing </li></ul></ul>
  52. 52. Conclusion -- Continued <ul><li>Short put positions are more prevalent than long put positions – especially so on value stocks </li></ul><ul><li>All three investor classes display trend-chasing behavior in their purchases of calls to open new positions. Returns as far back as 2 years in past matter </li></ul><ul><li>Least sophisticated investors dramatically increased purchases of calls to open new positions during the bubble, and this activity was focused in growth stocks </li></ul><ul><li>None of the investor groups increased purchases of puts during the bubble. Even when securities are available, investors do not seem to have the courage to bet against a bubble </li></ul>

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