Objective research to aid investing decisions

Value Investing Strategy (Strategy Overview)

Allocations for May 2022 (Final)
Cash TLT LQD SPY

Momentum Investing Strategy (Strategy Overview)

Allocations for May 2022 (Final)
1st ETF 2nd ETF 3rd ETF

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.

Smirking Because They Know Something?

Does the degree to which out-of-the-money (OTM) put options are “overpriced” imply future returns for associated stocks? In other words, are options traders especially well-informed? In their March 2008 paper entitled “What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?”, Xiaoyan Zhang, Rui Zhao and Yuhang Xing test whether option prices for individual stocks contain important information for the underlying equities. They focus on the predictive power of volatility smirks, the difference between the implied volatilities of OTM put options and at-the-money (ATM) call options. Using daily option and underlying stock price data for all firms with listed options during 1996-2005, they conclude that: Keep Reading

Extracting Disaster from Index Option Prices

Does the “overpricing” of out-of-the-money (OTM) stock index put options imply an investor estimate of the likelihood and size of economic disasters and stock market crashes? In his June 2008 paper entitled “How Bad Will the Potential Economic Disasters Be? Evidences From S&P 500 Index Options Data”, Du Du estimates the the frequency and magnitude of U.S. economic disasters as implied by S&P 500 index option data within a model involving rare sharp drops in consumption and consumption habit formation. In his model, consumption drops induce stock market crashes via: (1) commensurate declines in dividends, and (2) elevated investor risk aversion. Using S&P 500 index option data for the period 4/4/88-6/30/05 and contemporaneous economic data, he concludes that: Keep Reading

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: Keep Reading

The Volatility Risk Premium and De-biased Equity Option Returns

Should speculators expect a profit from assuming the risk of volatility (for example, by selling options)? In their October 2007 paper entitled “The Price of Market Volatility Risk”, Jefferson Duarte and Christopher Jones employ a combination of simulations and analyses of empirical data to investigate the volatility risk premium. This premium ostensibly provides compensation for those assuming risks stemming from both option contract characteristics and the price variability of the underlying equity. The study addresses biases, induced by large bid-ask spreads, in typical approaches to calculating mean returns for options. Using daily data for options on U.S. equities spanning 1996-2005, they conclude that: Keep Reading

Best-of-Breed for Get-Rich-Quick Option Tips

The unreal deal, as found in the cyber-alleys off Wall Street… Keep Reading

Consistently Expensive Types of Equity Options

Are some types of equity options consistently overpriced compared to others? If so, are there ways to exploit the pricing differences? In the December 2006 update of their paper entitled “Systematic Variance Risk and Firm Characteristics in the Equity Options Market”, Vadim di Pietro and Gregory Vainberg investigate differences in options pricing between individual stocks and indexes and between different types of stocks (small versus large capitalization and value versus growth). Specifically, they examine mismatches between implied and realized (actual) asset volatilities as measured by returns from synthetic variance swaps, which are constructed from combinations of options and futures on underlying assets. Using stock and option prices and associated firm fundamental data for 1,402 firms over the period 1/96-12/04, they conclude that: Keep Reading

Strategies for Investing in Options of Individual Stocks

Are there ways that individual investors can systematically use options for individual stocks to enhance portfolio returns? In their September 2007 paper entitled “Firm Specific Option Risk and Implications for Asset Pricing”, James Doran and Andy Fodor examine the benefits and costs of 12 basic strategies for augmenting an initial investment in a group of stocks with systematic investments in the associated options. Options positions are initially 75-90 days to expiration and held to maturity. For each strategy, the authors test sensitivity to the size and moneyness (at the money, in of the money and out of the money) of options investments. Using stock and option prices and associated firm fundamental data for the 213 companies over the period 1/96-7/06, they conclude that: Keep Reading

Is 40% Per Month Shorting Index Puts a Fair Return?

Selling put options, with limited upside and potentially very large downside, seems very risky. Are actual returns from selling puts commensurate with the risk? In the May 2004 version of his paper entitled “Why are Put Options So Expensive?”, Oleg Bondarenko confirms large returns for shorting puts options on futures for a broad market index and investigates whether these large returns: (1) represent normal risk premiums; (2) are reasonably priced protection against market crashes; or, (3) indicate incorrect investor beliefs about the probability of negative market returns (crashes). Using a flexible testing methodology and daily price data for put options on S&P 500 index futures during 8/87-12/00, he concludes that: Keep Reading

Abnormal Returns from Selling Index Put Options?

Are equity investors on average irrationally afraid of market plunges, and therefore willing to overpay for index put options? In their October 2004 paper entitled “A Portfolio Perspective on Option Pricing Anomalies”, Joost Driessen and Pascal Maenhout investigate the benefits of index options positions to asset allocating investors. In the June 2007 version of their paper entitled “Understanding Index Option Returns”, Mark Broadie, Mikhail Chernov and Michael Johannes compare historical option returns to those generated by commonly used option pricing models. These studies find that: Keep Reading

Good Deals in Broad Market Index Options?

Are investors on average overly fearful/greedy regarding overall stock market volatility, and therefore willing to overpay for insurance/leverage in the form of broad market index options? If so, what reliable strategies could a trader use to exploit this fear and capture the overpayments? In their January 2006 paper entitled “Option Strategies: Good Deals and Margin Calls”, Pedro Santa-Clara and Alessio Saretto investigate potential mispricings of S&P 500 index options and a range of trading strategies that might exploit those mispricings. Using daily S&P 500 index options data from the Chicago Mercantile Exchange for January 1985-May 2001 and from the Chicago Board Options Exchange for January 1996-May 2004, they conclude that: Keep Reading

Login
Daily Email Updates
Filter Research
  • Research Categories (select one or more)