Equity Options

Are options for volatile stocks overpriced? In the September 2010 version of their paper entitled “Cross-Section of Option Returns and Stock Volatility”, Jie Cao and Bing Han investigate the relationship between option return and price volatility of the underlying stock. The focus on delta-hedged positions in options and underlying stocks calibrated such that the combination is insensitive to stock price changes. For most analyses, they use the closing bid-ask midpoint as the option price. Using price and trading data for approximately at-the-money individual stock options about 1.5 months from expiration (filtered for reliability) on approximately 6,000 underlying U.S. stocks over the period January 1996 through October 2009 (about 200,000 observations each for puts and calls), they find that: Keep Reading

Do options quote movements anticipate those of underlying stocks? In other words, are options traders systematically more informed than stock traders? In their January 2011 paper entitled “Is There Price Discovery in Equity Options?”, Dmitriy Muravyev, Neil Pearson and John Paul Broussard test the lead-lag relationship between the bid-ask ranges of equity options and the actual bid-ask ranges of underlying stocks by comparing instances when the two markets disagree with instances when they do not. Disagreement means that the stock bid-ask range implied by the put-call parity relation does not overlap with the actual stock bid-ask range. This approach is more definitive than a simplification based on the midpoint of the bid-ask range. Using tick-by-tick trade and quote data for 36 liquid U.S. stocks and three exchange-traded funds (ETF) and options on them during April 17, 2003 through October 18, 2006 (107,000 instances of disagreement), they find that: Keep Reading

A reader asked: “Do you have any research on the phenomenon of ‘pinning’ during options expiration? The theory is that there is a Max Pain price where options sellers stand to lose the least, and that they manipulate prices towards these levels.” A search of the Social Science Research Network (SSRN) separately for “pinning” and “expiration” yields the following studies, in descending order of number of downloads: Keep Reading

Author Jeff Augen describes his 2010 book Trading Realities: The Truth, the Lies, and the Hype In-Between as “designed to help investors understand the economic and political forces that drive financial markets and to invest alongside those forces instead of against them. It also provides a blunt assessment of the limitations that most private investors face. Understanding these limitations and being able to manage risk are as important as choosing the right investments.” Some notable points from the book are: Keep Reading

Are there predictable times when selling covered call options outperforms selling cash-covered put options? In his March 2010 paper entitled “Buy-Write or Put-Write, An Active Portfolio to Strike it Right” (the National Association of Active Investment Managers’ 2010 Wagner Award runner-up), George Yang investigates using trend signals to trigger switching between covered call and put writing. The test portfolio consists of: (1) a long position in the S&P 500 Total Return Index (SPTR); (2) cash (Treasury bills); and, (3) a short position equivalent to the value of (1) plus (2) in at-the-money, next-month call or put options on the S&P 500 Index. The Golden Cross/Black Cross Rule (the 50-day simple moving average crossing above/below the 200-day simple moving average) applied to SPTR triggers switches between calls (after black crosses) and puts (after golden crosses). Using daily closes for SPTR, the S&P 500 Buy-Write Index (BXM) and the S&P 500 Put-Write Index (PUT) during June 1988 through December 2009 (21.6 years), he finds that: Keep Reading

Reader Jeff Partlow passed along the question of whether options on Exchange-Traded Funds (ETF) are Section 1256 contracts, qualifying for 60% long-term and 40% short-term capital gains treatment. Using applicable parts of U.S. Code Section 1256 and IRS Publication 550, we find that: Keep Reading

Does reluctance of traders to hold naked short positions in individual stock options over weekends induce a weekend effect for option prices? In the February 2010 revision of their paper entitled “The Weekend Effect in Equity Option Returns”, Christopher Jones and Joshua Shemesh employ a portfolio approach to investigate a weekend effect for put and call options on U.S. stocks. They compute portfolio excess returns as the equally weighted average of individual option contract returns based on bid-ask midpoints, in excess of a short-term yield. Using price data for a filtered set of U.S. equity options and for the underlying stocks over the period January 1996 to June 2007, they conclude that: Keep Reading

Reader Jeff Partlow asked and wondered: “Are you aware of research on the before and after impacts of company earnings releases on option prices? As a covered calls investor, I have gone back and forth about whether the increased option premiums available prior to earnings release makes it more advantageous to: (1) sell options prior to earnings release to take advantage of elevated premiums; or, (2) avoid companies with an impending earnings release to avoid the risk of negative earnings surprises.” Keep Reading

Do returns for covered calls on individual stocks vary systematically with stock volatility and liquidity? In the January 2010 version of their paper entitled “Option Returns and Individual Stock Volatility”, Jie Cao and Bing Han compare monthly returns of portfolios of short-term (formed about 1.5 months from expiration and held one month), at-the-money covered call options sorted by either total volatility (standard deviation of daily stock returns over the previous month) or idiosyncratic (market-independent) volatility of the underlying stocks. They also examine a double sort by market capitalization and total volatility. Using daily stock and option price data for a broad sample of U.S. equities over the period January 1996 through December 2006, they conclude that: Keep Reading

Covered Calls Advisor Jeff Partlow commented: “Selling a cash-secured put is essentially equivalent to a covered call when done at the same strike price and expiration date. But I’ve observed that cash-secured put sellers tend to select more conservative out-of-the-money strike prices, whereas covered call sellers tend to establish more aggressive out-of-the-money strike prices. Also, the result in ‘Outperformance from Mechanically Selling Covered Calls on a Stock Index’ is questionable to me because the July 2004 ‘Passive Options-based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index’ by Ibbotson Associates and the October 2006 ‘An Historical Evaluation of the CBOE S&P 500 BuyWrite Index Strategy’ by Callan Associates show, respectively, that 2% out-of-the-money and at-the-money covered call strategies outperform a buy-and-hold approach.” Keep Reading