Do Informed Traders Tip Their Hands Via Option Purchases?

Do traders with solid information about firm prospects use equity options to get leverage and avoid short selling constraints? Two recent papers address this question by testing the predictive power of distortions in out-of-the money option prices for individual stocks. In their December 2007 paper entitled “Deviations from Put-Call Parity and Stock Return Predictability”, Martijn Cremers and David Weinbaum examine the power of relatively expensive options to predict returns for individual stocks. In a similar March 2008 paper entitled “What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?”, Xiaoyan Zhang, Rui Zhao and Yuhang Xing focus on relatively expensive put options as indicators of bad news and poor future returns for individual stocks. Using options pricing and associated stock return data over the period 1996-2005, these two studies conclude that:

By examining the difference in implied volatilities (volatility spread) between call and put options with the same strike price and expiration date for the same stock, the authors of “Deviations from Put-Call Parity and Stock Return Predictability” find that:

• A hedge portfolio reformed weekly at the market open that is long (short) stocks with relatively expensive calls (puts) earns an average value-weighted, risk-adjusted weekly abnormal return of 0.51% over the entire sample period. The relatively expensive calls (puts) make a positive (negative) contribution to this return. The return grows at a diminishing pace for longer holding periods, with no reversal.
• Options with more leverage (further out-of-the-money) offer stronger predictability.
• This volatility spread strategy is on average contrarian, buying stocks that have underperformed the market by 0.84% the preceding week.
• Predictability seems to reflect a preference of informed traders for options over equity.
• The predictive power of the volatility spread decreases over the sample period.

By examining the volatility smirks (differences between the implied volatilities of at-the-money calls and out-of-the-money puts) for individual stocks, the authors of “What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?” find that:

• The options of most individual stocks exhibit some volatility smirk (elevated aversion to downside risk).
• A hedge portfolio that is long (short) stocks with the flattest (steepest) smirks, reformed weekly, generates a risk-adjusted return of about 15% per year.
• This predictability persists for at least six months.
• Firms with steepest volatility smirks (put option prices that traders have bid to relatively high levels) experience the worst negative earnings shocks the next quarter.
• Results suggest that: (1) traders with valuable negative information about a company prefer to buy out-of-the-money put options rather than short the stock, and (2) the equity market is slow to follow this signal.

The hedge portfolio returns in these studies apparently do not include trading costs/frictions.

In summary, evidence supports beliefs that informed traders distort the relationship between the prices for put and call options on individual stocks and that others may be able to exploit these distortions. Relatively expensive calls (puts) predict stock outperformance (underperformance).

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