The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Thursday, August 17, 2006

What Options Trading Can Tell Us About Stock Prices

Professors Jun Pan, of MIT, and Allen Poteshman, of the University of Illinois at Urbana-Champaign, conducted research into how much information about the expectation of future stock prices are encoded in the trading behavior of options traders. In their paper, The Information in Option Volume for Future Stock Prices (which will be published in an upcoming issue of the The Review of Financial Studies), the professors conclude that there is strong evidence for option trading volumes containing substantial information about future stock prices.

The gist of this paper is that stocks with a low put to call ratio -- based on trading volume (adjusted to focus in on new trading positions as opposed to re-adjustments of existing positions and/or market making transactions) -- tended to outperform those with high ratios. Why? A low put to call trading volume ratio (suitably adjusted) for a stock means that option traders expect that the price will rise in the future since a low ratio means a greater interest in calls (which is a long position). A high ratio for a stock would mean that option traders expect the stock price to drop since a high ratio means a greater interest in puts (reflecting a short position).

A hypothetical portfolio using these relationships was found to consistently produce double digit returns even during bear markets. This phenomenal performance does require frequent trading (the researchers hypothetically re-adjusted their portfolio weekly). Frequent trading would entail high transaction costs which would dampen performance. However, the returns were still fairly high (at least for institutional investors who get favorable transaction fees). Without taking into account transaction costs, the annualized return was 62% over the 12 years studied (1990 to 2001); with transaction costs (for institutional investors with low costs) the return would have been around 50% annually.

In order to arrive at these results, Professors Pan and Poteshman had to use a proprietary database from the Chicago Board Options Exchange. Without this unique dataset, it would have been extremely difficult to focus in on trading volume that reflected trading information that would have been relevant to their thesis. This is an example of the importance of having proper and useful data in econometrics and statistical analysis.

By the way, this private data on trading volume is now available to investors. Thus, what was once semi-private information will now become public information. A lot of the informational advantages found in the research will probably be aribitraged away. The degree to which the markets are efficient are debatable, but the markets should be efficient enough to trim the informational advantages so that the fantastic returns from the hypothetical portfolio in the paper will be reduced considerably.


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