Equity Options

Can investors/speculators use equity options to boost return through buying and selling leverage (calls), and/or buying and selling insurance (puts)? If so, which strategies work best? These blog entries relate to trading equity options.

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Expected Volatility of Stock Market Volatility as a Predictor

S&P 500 Index options data imply expected S&P 500 Index volatility (VIX) over the next month. In turn, VIX futures options data imply expected volatility of VIX (VVIX) over the next month. Does VVIX predict stock index option and VIX option returns? In their September 2014 paper entitled “Volatility-of-Volatility Risk”, Darien Huang and Ivan Shaliastovich investigate whether VVIX represents a time-varying risk affecting: (1) S&P 500 Index option returns above and beyond the risk represented by VIX; and (2) VIX futures option returns. They measure risk effects via returns on S&P 500 Index options hedged daily by shorting the S&P 500 Index and VIX futures options hedged daily by shorting VIX futures. Using monthly S&P 500 Index returns, VIX futures returns, VIX, VVIX, S&P 500 Index option prices and VIX option prices during February 2006 through June 2013, they find that: Keep Reading

Simple Stock Index Option Strategies

Do simple stock index option strategies (stock-covered calls, cash-covered puts and collars) outperform the underlying index? To investigate, we examine first the performance of the CBOE S&P 500 BuyWrite Index (BXM), the CBOE S&P 500 PutWrite Index (PUT) and the CBOE S&P 500 95-110 Collar Index (CLL), with the S&P 500 Total Return Index SPTR) as a benchmark. Since these series are modeled indexes rather than tradable assets, we then examine the relatively short records of exchange-traded funds (ETF) and notes (ETN) designed to track BXM, iPath CBOE S&P 500 BuyWrite Index ETN (BWV) and PowerShares S&P 500 BuyWrite (PBP), with SPDR S&P 500 (SPY) as a benchmark. Using end-of-month levels/total returns for SPTR, BXM, PUT and CLL since June 1986, and for SPYBWV and PBP since December 2007 (limited by inception of PBP), all through April 2014, we find that: Keep Reading

Best Option-based Stock Return Predictors?

Do implications of equity option prices predict returns for underlying stocks? In their December 2013 paper entitled “Option-Implied Volatility Measures and Stock Return Predictability” Xi Fu, Eser Arisoy, Mark Shackleton and Mehmet Umutlu compare the abilities of various option-implied volatility metrics to predict returns for individual stocks at horizons of one to three months. Specifically, they consider:

  • Call-Put Implied Volatility spread (CPIV): difference between at-the-money call and at-the-money put implied volatilities.
  • Implied Volatility Skew (IVSKEW): difference between out-of-the-money put and at-the-money call implied volatilities.
  • Above-Minus-Below (AMB): difference between average of in-the-money put and out-of-the-money call implied volatilities and average of in-the-money call and out-of-the-money put implied volatilities.
  • Call Out-Minus-At (COMA): difference between out-of-the-money call and at-the-money call implied volatilities.
  • Put Out-Minus-At (POMA): difference between out-of-the-money put and at-the-money put implied volatilities.
  • Realized Volatility-Implied Volatility spread RVIV): difference between realized volatility (annualized standard deviation of daily returns over the previous month) and implied volatility.

Each month, they rank stocks into quintiles based on each of these six metrics. They then form respective capitalization-weighted and equal-weighted hedge portfolios that are long (short) the quintiles with the highest (lowest) values of each metric and hold for one month. They also perform regressions to control portfolio returns over one, two and three months for a variety of market, stock and option characteristics. Using firm financial statement data, monthly and daily stock returns and monthly option-implied volatilities (from options with maturities of one to three months) during February 1996 through December 2011 (191 months), they find that: Keep Reading

Trading Around Option Expiration Days

Are there any stock market return/volatility anomalies around the equity option expiration (OE) day (third Friday of each month)? Potential anomalies include: (1) systematic differences in returns and volatilities before, on and after OE; and, (2) systematic differences in OE returns conditional on prior-month returns. To investigate, we examine close-to-close returns from five trading days before through five trading days after OE. Using daily closing prices for the S&P 500 Index for January 1990 through December 2013 (287 OEs, with September 2001 excluded due to trading disruption) and for the iPath S&P 500 VIX Short-Term Futures ETN (VXX) during January 2009 through December 2013 (59 OEs), we find that: Keep Reading

Index Option Strike Price Volume Dispersion as a Return Predictor

Is the level of uncertainty among equity investors, as measured by the dispersion of S&P 500 Index option volume across strike prices, a useful predictor of stock market direction? In their January 2014 paper entitled “Stock Market Ambiguity and the Equity Premium”, Panayiotis Andreou, Anastasios Kagkadis, Paulo Maio and Dennis Philip investigate the ability of this dispersion in investor speculations (designated stock market “ambiguity”) to predict stock market returns. They argue that stock market ambiguity is a direct, forward-looking and readily computed indicator. They compare ambiguity to other commonly cited stock market predictors, with focus on the variance risk premium VRP). Using trading volumes for S&P 500 Index call and put options with maturities of 10 to 360 calendar days on the last trading day of each month, monthly data needed to calculate competing indicators and monthly returns for the broad U.S. stock market during 1996 through 2012, they find that: Keep Reading

Stock Return-Implied Volatility Two-way Feedback

Is there exploitable feedback between stock returns and behaviors of associated options due to concentration of informed traders in one market or the other? In the October 2013 version of their paper entitled “The Joint Cross Section of Stocks and Options”, Byeong-Je An, Andrew Ang, Turan Baliand and Nusret Cakici investigate lead-lag relationships between stock returns and changes in associated option-implied volatilities. In case there is some asymmetry, they examine call option and put option implied volatilities separately. They focus on near-term options with delta of 0.5 and expiration in 30 days. Using daily stock returns and associated call and put option implied volatilities (available from OptionMetrics), firm fundamentals and risk adjustment factors during January 1996 through December 2011, they find that: Keep Reading

Predictive Power of Put-Call Ratios

The conventional wisdom is that a high (low) ratio of equity put option volume to equity call option volume is bullish (bearish) because it indicates that investors are overly pessimistic (optimistic). Alternative measurements of the U.S. equity market put-call ratio are total options, index options and individual equity options. Index and equity option buyers may have different motives. Alternative sources of put-call ratios are the Chicago Board Options Exchange (CBOE) and the International Securities Exchange (ISE). CBOE counts volumes for all options transactions. ISE relies on “a unique put/call value that only uses opening long customer transactions to calculate bullish/bearish market direction. Opening long transactions are thought to best represent market sentiment because investors often buy call and put options to express their actual market view of a particular stock. Market maker and firm trades, which are excluded, are not considered representative of true market sentiment due to their specialized nature. As such, the…calculation method allows for a more accurate measure of true investor sentiment…” Do the alternative put-call ratios confirm conventional wisdom? Using available historical daily data for CBOE and ISE total, index and equity option put-call ratios and contemporaneous dividend-adjusted levels of S&P Depository Receipts (SPY) through mid-February 2013, we find that: Keep Reading

Option Straddles Around Earnings Announcements

Does market underestimation of stock price uncertainty around earnings announcements support a short-term straddle strategy (call option and put option with matched strike and expiration, profitable with large stock price moves)? In their January 2013 paper entitled “Anticipating Uncertainty: Straddles Around Earnings Announcements”, Yuhang Xing and Xiaoyan Zhang investigate the performance of short-term, near-the-money straddles during intervals around earnings announcements. Short-term means no more than 60 days to expiration. Near-the-money means moneyness in the range 0.95 to 1.05. They focus on a delta-neutral straddle constructed by appropriately weighting the call and put positions at initiation, but they also consider a simple one call-one put alternative. They examine several straddle holding periods starting at the close five, three or one trading day before scheduled earnings announcement date and ending at the close on or one day after earnings announcement date. They calculate option returns based on the mid-point of the daily closing bid and ask as a fair option price (and require it to be at least $0.125). Using daily stock returns and option prices (with data filtered to exclude implausible data), along with contemporaneous quarterly firm fundamentals, during January 1996 through December 2010, they find that: Keep Reading

How to Beat Equal Weight Asset Allocation?

Are there strategic asset allocation methodologies that reliably beat equal weight? In the February 2012 version of their paper entitled “Portfolio Optimization Using Forward-Looking Information”, Alexander Kempf, Olaf Korn and Sven Sassning investigate the performance of a minimum variance portfolio based on returns implied by equity options rather than historical returns. They argue that, since option prices reflect the expectations of market participants, the former approach is inherently forward-looking. The methodology involves calculating option-implied volatilities and option-implied correlations. Using daily prices for the Dow Jones Industrial Average (DJIA) stocks and associated option-implied return statistics during 1998 through 2009 for out-of-sample testing, and DJIA stock prices for 1993 through 1997 for historical data tests, they find that: Keep Reading

Stock Returns and Changes in Implied Volatility

Do informed options traders know more than other traders? In other words, are there reliable and exploitable predictive relationships between changes in implied volatility and future returns for associated stocks? In the February 2012 version of their paper entitled “The Joint Cross Section of Stocks and Options”, Andrew Ang, Turan Bali and Nusret Cakici investigate the relationship between changes in implied volatility and stock returns for individual stocks. They consider both call-implied and put-implied volatilities based on near-term expirations. Using daily implied volatilities, associated daily stock prices and firm accounting data for a broad sample of U.S. stocks over the period January 1996 through September 2008 (153 months), they conclude that: Keep Reading

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