Sunday, August 13, 2006

Does Option Volume Predict Stock Movements?

Mark Hulburt of the New York Times highlights some interesting academic research in the New York Times. He reports on a paper by Jun Pan of the Sloan School of Management at the Massachusetts Institute of Technology and Allen M. Poteshman of the University of Illinois , titled at Urbana-Champaign. The study, titled “The Information in Option Volume for Future Stock Prices,” is forthcoming in the fall 2006 issue of the Review of Financial Studies.

Using a new database from the Chicago Board Options Exchange (CBOE), Pan and Poteshman calculated the relative volume of new call option (i.e. an option to buy a given stock) and put option (i.e. an option to sell a given stock) positions and related them to subsequent stock returns. They find that stocks with higher call-to-put-option ratios outperformed their low-ratio peers by about 1% per week.

Although the Journal is subscription only (and, since it's an NBER paper the SSRN version is also not free), the abstract is up at SSRN:
We present strong evidence that option trading volume contains information about future stock price movements. Taking advantage of a unique dataset from the Chicago Board Options Exchange, we construct put-call ratios from option volume initiated by buyers to open new positions. On a risk-adjusted basis, stocks with low put-call ratios outperform stocks with high put-call ratios by more than 40 basis points on the next day and more than 1% over the next week. Partitioning our option signals into components that are publicly and non-publicly observable, we find that the economic source of this predictability is non-public information possessed by option traders rather than market inefficiency. We also find greater predictability from option signals for stocks with higher concentrations of informed traders and from option contracts with greater leverage.
You can read Hulburt's piece here.

Pan and Poteshman's results make sense since options have what is known as "leverage": a small percentage change in a stock's price can cause a relatively large percentage change in the price of its associated options). So, informed traders would be much better off trading in the options market rather than in the stock market. Therefore, their trading pattens should provide information about future stock movements.

Until now, it was impossible to separate volume from new options positions from volume from other options trades. But, the new dataset made it possible.

Pan and Poteshman did caution, however, that the strategy might not be feasible for small investors - the strategy has high transaction costs , since it require frequent trading. So, it might not work except for institutional players, who can trade at extremely low costs (and the database also costs $600 per month, whih isn't cheap).

All in all, a very nice piece, and worth a read (if you have access to the Review of Financial Studies).

Update 10/14: Here's a link to a copy of the paper as presented at the University of Minnesota in 2oo4. I haven't seen the final published version yet, so there may be some differences betweeen this and the final version. But for those of you without access to the Review of Financial Studies, it will at least give you access. And a big thanks to reader Jake Wolf for the link (isn't the internet grand?)

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