The Information in Option Volume for Stock Prices

Jun PanMI T Sloan School of Management

Allen M. PoteshmanUniversity of Illinois at Urbana-

Champaign

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Derivatives in Financial Markets

The traditional view of derivatives: redundant via dynamic trading of the underlying security.Empirical evidence: not completely redundant.

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Why Trade Derivatives?Risk sharing, in an otherwise incomplete market [Ross 1976]: Multiple risk factors [Bates (2002), Liu and Pan (2002)] Dynamic trading not allowed [Haugh and Lo (2001)] Other market frictions: short-sale constraints [Basak

and Croitoru (2000)], non-hedgeable background risk [Franke, Stapleton, and Subrahmanyam (1998)]

Differences of Opinion [Kraus and Smith (1996), Bates (2002), Buraschi and Jiltsov (2002)]Information Trading [Black (1975), Back (1993), Easley, O’Hara, and Srinivas (1998)]

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“Fact and Fantasy in the Use of Options” (Fischer Black, 1975)“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.

Also, it is easier to take a short position by writing options than by shorting the underlying stock…

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.”

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Return to 1 month ATM call as a function of return to stock

-30 -20 -10 0 10 20 30-100

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Return to the Underlying Stock (%)

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Informed Option Trading: Mixed Empirical Evidence

Option volume contains information before important firm specific news

Earnings announcements [Amin and Lee (1997)] Takeover annnouncements [Cao, Chen, and Griffin (2002)]

During “normal” times, stock volume not option volume predicts underlying stock returns

Daily intervals [Cao, Chen, and Griffin (2002)] Intraday [Chan, Chung, and Fong (2002)]

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

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Main Empirical Finding

Clear evidence that option volume in general does contain information about future stock price movementsPut/call ratios constructed from equity option volume are significant predictors of cross-sectional stock returns for at least one week into the future

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Option Dataset

Daily records of CBOE trading volume for all CBOE listed options from January 1990 through December 2001Each option is identified by its underlying stock or index, as a put or a call, and by its strike price and time to expirationA 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

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Trade TypesEach option transaction is identified as: Open buy: buyer initiated to open a new position Open sell: seller initiated to open a new position Close buy: buyer initiated to close an existing short position Close sell: seller initiated to close an existing long position

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.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.

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Investor ClassesThe volume data is further categorized according to which of the following four investor classes initiates the trades: Firm proprietary traders Public customers of discount brokers Public customers of full-service brokers Other public customers

Trades initiated by market makers are not recorded in our data.

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Table 1: Option trading volume by trade type and investor class

Open buy Open sell Put Call Put Call Small Stocks Avg volume (Contracts) 16 53 18 49 % Firm Proprietary 7.48 4.46 5.42 4.09 % Discount 7.35 12.92 9.96 11.97 % Full-service 72.61 71.73 75.84 73.66 Medium Stocks Avg volume (Contracts) 38 96 36 89 % Firm Proprietary 10.87 8.81 9.89 7.62 % Discount 8.49 12.48 9.38 9.97 % Full-service 69.22 67.90 71.38 72.37 Large Stocks Avg volume (Contracts) 165 359 135 314 % Firm Proprietary 14.45 11.36 13.61 10.14 % Discount 9.77 13.18 7.83 8.02 % Full-service 63.60 64.70 69.68 71.98

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Information in Open Buy Volume

Trades initiated by buyers to open new positionsBuild daily cross-sections of stocks with liquid option trading – at least 50 contractsOn each day sort stocks into quintiles based on

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

. ./

. . . .

o b put volumeopen buy put call ratio

o b put volume o b call volume

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Table 3: Open Buy Volume Results Following Portfolio Formation

Day Relative to Portfolio Formation 0 +1 +2 +3 +4 +5 Panel A: Average Daily Returns of PC-Ranked Portfolios

(Basis Points) PC 1 (Low PC: Mostly Calls) 31.4 25.0 15.5 12.1 11.4 10.2 PC 2 28.6 27.2 12.1 8.3 6.8 6.1 PC 3 15.5 12.5 7.1 6.1 5.4 5.6 PC 4 13.0 -0.3 3.1 2.1 6.4 4.7 PC 5 (High PC: Mostly Puts) -5.9 -14.6 -6.1 -0.8 -0.7 1.4

Panel B: Average Daily Returns of Low-PC minus High-PC Portfolios (Basis Points)

PC 1 – PC5 37.4 39.6 21.6 12.9 12.1 8.8 T-statistic (19.77) (23.79) (13.11) (8.18) (7.77) (5.50)

Panel C: Same as Panel B, except excluding EADs and 5-Day Windows PC 1 – PC5 37.4 38.0 19.7 12.7 13.2 9.5 T-statistic (18.19) (21.33) (11.11) (7.46) (7.79) (5.38)

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Open Buy Volume FindingsAverage stock returns decrease with increasing PC-ranking for at least 5 days after portfolio formation.The average next day returns for highest and lowest PC portfolios are –14.6 bps and 25 bps, respectively. CRSP value-weighted return generates an average daily

return of 5 bps over the same period

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.

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Table 3: Open Buy Volume Results Leading up to Portfolio Formation

Day Relative to Portfolio Formation -5 -4 -3 -2 -1 0 Panel A: Average Daily Returns of PC-Ranked Portfolios

(Basis Points) PC 1 (Low PC: Mostly Calls) 1.7 0.7 -0.8 2.2 12.1 31.4 PC 2 -1.6 -2.4 -1.8 -3.9 2.3 28.6 PC 3 7.9 7.6 5.9 6.6 9.6 15.5 PC 4 15.6 16.9 17.4 18.2 19.6 13.0 PC 5 (High PC: Mostly Puts) 14.5 15.4 17.8 18.0 16.1 -5.9

Panel B: Average Daily Returns of Low-PC minus High-PC Portfolios (Basis Points) PC 1 – PC 5 -12.8 -14.7 -18.6 -15.8 -3.9 37.4 T-Statistic (-8.04) (-9.08) (-11.46) (-9.44) (-2.24) (19.77)

Panel C: Same as Panel B, except excluding EADs and 5-Day Windows PC 1 – PC 5 -11.3 -13.6 -17.0 -14.5 -1.7 37.4 T-Statistic (-6.54) (-7.86) (-9.56) (-8.15) (-0.90) (18.19)

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Table 5: Open Buy Volume by Year

Day Relative to Portfolio Formation Year –2 –1 0 +1 +2 +3 +4 +5 Panel A: Average Daily Returns of Low-PC minus High-PC Portfolios (in basis points) 1990 10.8 18.7 58.3 18.5 18.5 14.2 8.2 10.0 1991 -4.3 22.4 38.3 36.1 20.2 12.3 3.7 3.4 1992 -2.8 2.8 52.6 28.6 15.4 8.6 14.0 5.4 1993 -13.9 0.9 60.7 43.4 25.5 13.0 15.4 8.6 1994 -17.6 0.3 45.6 40.5 16.8 11.4 14.2 9.2 1995 -14.7 -9.3 47.5 40.4 20.6 9.3 9.2 6.4 1996 -23.8 -13.3 48.0 48.0 32.1 13.8 10.6 9.1 1997 -11.6 0.7 49.4 47.0 23.7 20.6 15.4 14.2 1998 -19.0 -6.9 36.7 48.3 24.5 22.0 10.0 6.5 1999 -26.7 -14.5 15.6 43.9 23.9 10.4 14.4 17.5 2000 -46.7 -48.9 -34.5 39.5 20.5 8.5 11.7 1.5 2001 -19.3 -0.1 29.9 40.6 17.7 10.9 18.5 13.9

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Closing Time Differences

The CBOE closes after the underlying stock market.Part of day +1 return may reflect information released on day 0 after stock market closes but before option market closesOn June 23, 1997, CBOE changed the closing time for equity options from 4:10 PM (EST) to 4:02 PM (EST).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.

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Temporary Price PressureSuppose market makers delta-hedge and non-market makers do not.Then a buyer initiated call transaction will result in market maker selling a call and hedging by buying delta shares.So, open buy call may result in upward price pressure on underlying stock even if the buyer of the call has no fundamental information.Temporary price pressure is not a promising alternative explanation

Price pressure would occur on day 0 There would be a price reversal

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Results by Firm Size

Sort cross-section of stocks into small, medium, and large groups.Average NYSE deciles are, respectively, 4.3, 7.8, and 9.8.Significant information in option volume for each size groupPredictability is stronger for smaller stocks which is consistent with information flow for large stocks typically being more efficient

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Table 6: Open Buy Volume by Firm Size

Day Relative to Portfolio Formation Firm Size 0 +1 +2 +3 +4 +5

Panel A: Average Daily Return of Hedge Portfolio (bps) Small 93.7 65.0 27.3 17.1 15.4 6.3

Medium 22.6 35.4 18.1 11.9 8.1 6.4 Large 1.0 18.0 11.3 5.9 5.3 2.6

Panel B: T-Statistics Small 21.56 17.41 7.73 4.93 4.39 1.87

Medium 9.41 15.86 7.76 5.21 3.63 2.81 Large 0.60 11.26 6.98 3.73 3.29 1.65

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Results by Investor Class

Four investor classes Firm proprietary traders Customers of discount brokers Customers of full-service brokers Other public customers

Results speak directly to the issue of whose option volume is informative – not to the issue of who is more informed.

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Table 6: Results by Investor Type

Day Relative to Portfolio Formation Investor Type 0 +1 +2 +3 +4 +5

Panel C: Average Daily Return of Hedge Portfolio (in basis points) Firm Propr. 63.1 1.1 -0.2 1.9 1.9 -0.5 Discount -49.8 22.7 10.1 9.7 3.9 3.3

Full-Service 39.9 41.1 22 16.5 11.7 8.6 Other Public 31.7 32.9 13.1 8.9 3 8.6

Panel D: T-Statistics Firm Propr. 14.39 0.3 -0.06 0.55 0.57 -0.14 Discount -13.39 7.28 3.4 3.33 1.34 1.13

Full-Service 19.38 23.11 12.45 9.59 7.04 4.93 Other Public 8.1 10.07 4.13 2.83 0.89 2.88

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Relationship to Known Cross-Sectional Relations

Run daily cross-sectional regressions with +n day stock return on Open buy put-call ratio Size NYSE BM decile Momentum decile Past week return Analyst coverage Ratio of option volume to und. stock volume

Cross-sectional predictability is robust to these known cross-sectional relations.

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Table 7: Daily Cross-Sectional Regressions [T-Statistics]

Intercept P/(P+C) ln(sz)

× P/(P+C) option/stock × P/(P+C)

ln(1+A) × P/(P+C) ln(sz) option/stock ln(1+A) BM mom

Panel A: +1-day Return as Dependent Variable 1 -51

[0.62] [-27.69] 25.3 -49.3 -1.1 -0.1 -1 -0.1 1

[3.49] [-29.09] [-1.95] [-1.66] [-0.82] [-0.27] [2.87] 57.8 -173.3 15.8 0.8 -3.4 -5.3 -0.3 0.5 -0.2 1

[6.67] [-14.95] [12.13] [3.88] [-0.88] [-6.95] [-3.11] [0.27] [-0.61] [3.05] Panel B: +2 Day Return as Dependent Variable

12.5 -24.2 [4.19] [-13.67]

2.7 -25 0.5 0.04 -0.1 -0.1 1.1 [0.39] [-15.39] [0.86] [0.59] [-0.08] [-0.42] [3.33] 23.1 -96.2 8.7 0.3 -3 -2 -0.1 -0.2 1.1

[2.87] [-7.79] [6.27] [1.38] [-0.78] [-2.82] [-0.59] [-0.68] [3.33] Panel C: +5 Day Return as Dependent Variable

7.9 -8.9 [2.67] [-5.19] -1.1 -9.1 0.5 -0.2 1 -0.1 0.9

[-0.16] [-5.74] [0.98] [-2.68] [0.82] [-0.19] [2.69] 5.6 -32.1 2.8 -0.2 -0.7 -0.3 -0.1 1.1 -0.1 0.9

[0.75] [-3.09] [2.41] [-1.13] [-0.19] [-0.49] [-1.45] [0.67] [-0.21] [2.68]

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Information in Aggregate Volume

General public sees only total option volume, not option volume broken down by trade type.We aggregate option volume across four trade types to obtain a close proxy to publicly observable total option volume.There is still significant predictability, but its magnitude and duration are much less than for open buy volume.Similar results when we construct actual CBOE trading volume from trade data in Berkeley Option Data Base (1/1987-12/1996)

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Table 8: Results for Publicly Observable Volume

Day Relative to Portfolio Formation Volume Type 0 +1 +2 +3 +4 +5

Average Daily Return (in basis points)

Aggregate 98.9 16.1 4.4 2.3 0.7 3.1 Berkeley Options DB 85.8 13 3.8 1.3 2.3 1.2

T-Statistics

Aggregate 72.04 13.05 3.56 1.87 0.54 2.5 Berkeley Options DB 57.11 9.96 2.95 0.97 1.78 0.95

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Table 8: Results by Volume Type

Days Relative to Portfolio Formation Volume Type 0 +1 +2 +3 +4 +5

Panel A: Average Daily Return (in Basis Points) Open Buy 37.4 39.6 21.6 12.9 12.1 8.8 Open Sell 158.6 -7.9 -8.6 -6.4 -6.8 -3.5 Close Buy -85.6 7 8.7 3.5 4.5 4.2 Close Sell 195.9 -5.9 -12.4 -4.5 -3 -1.2

Panel B: T-Statistics Open Buy 19.77 23.79 13.11 8.18 7.77 5.5 Open Sell 79.84 -5.02 -5.5 -4.04 -4.34 -2.27 Close Buy -35.45 3.59 4.61 1.85 2.35 2.24 Close Sell 76.52 -2.91 -6.34 -2.32 -1.55 -0.62

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Information in Index Option Trading

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)Investigating whether option market investors possess information about future price moves of stock market as a wholeNo evidence of informed trading in index options

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Work in Progress

Is there information for future stock prices in publicly observable option market data?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.

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Conclusion

We produce strong evidence that option volume contains information about the future movements of underlying stock pricesThe predictability stretches a week into the future and is strongest for small stocksOption trading of customers of full-service brokers is most informativeWe do not find any evidence of informed trading in the index option marketWork in progress examines profitably of strategies that trade in the stock market based upon publicly observable option market data