Equity Options

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

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

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

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

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

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

Are there systematic errors in market expectations about the future volatilities of individual stock prices? If so, what reliable strategy could a trader use to exploit these errors? In their August 2006 paper entitled “Option Returns and the Cross-Sectional Predictability of Implied Volatility”, Amit Goyal and Alessio Saretto examine the complete range of implied stock price volatilities for all U.S. equity options to devise an volatility forecasting model more efficient than that inherent in the market. They then test the model’s ability (out of sample) to identify outperforming options trading strategies that exploit this market inefficiency. Using daily data for all U.S. equity options over the period January 1996 to May 2005, they conclude that: Keep Reading

How do individuals really trade in equity options? Do they mostly just buy speculative calls and protective puts? In their May 2006 paper entitled “Option Market Activity”, Josef Lakonishok, Inmoo Lee, Neil Pearson and Allen Poteshman examine actual option trading behaviors of firm proprietary traders (most sophisticated), customers of full-service brokers (including hedge funds?) and customers of discount brokers (least sophisticated). Using a unique dataset with detailed purchase-write and open-close transaction information for each equity option series listed by the Chicago Board Options Exchange (CBOE) from 1990 through 2001, they conclude that: Keep Reading

Are value (growth) investors stolid conservatives (wild risk-takers)? If so, is there a way to trade on the difference in behavioral preferences? In their September 2006 paper entitled “Risk Aversion and Clientele Effects”, Douglas Blackburn, William Goetzmann and Andrey Ukhov compare the risk preferences of value and growth investors by examining: (1) option prices for pairs of value-growth indexes, and (2) funds flows for value and growth mutual funds. They further investigate whether any profitable options trading strategies devolve from the difference in risk preferences. Using recent data for five value-growth index pairs and for several value and growth mutual funds, they find that: Keep Reading

Does a willingness to pay more or less for options than indicated by recent actual levels of stock return volatility reflect the current level of investor/trader risk aversion? In other words, does the gap between option-implied and historical stock return volatilities provide a tradable measure of fearfulness? In the September 2006 draft of their paper entitled “Expected Stock Returns and Variance Risk Premia”, Tim Bollerslev, George Tauchen and Hao Zhou investigate the predictive power of the implied-historical volatility gap for future stock returns. Using monthly data for the S&P 500 index (VIX for implied volatility and a summation of five-minute squared returns for historical volatility) for the period 1990-2005, they find that: Keep Reading