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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.

Are Some Covered Calls More Profitable Than Others?

On what kind of stocks can covered call writers obtain the best returns? In their July 2009 paper entitled “Cross-Section of Stock Option Returns and Individual Stock Volatility Risk”, Jie Cao and Bing Han investigate how delta-hedged stock option returns vary with volatility risk. They measure this return as the change in value of a self-financing portfolio that is long the call and short the underlying stock, rebalanced daily so that it is not sensitive to stock price movement. They assume trade execution at the mid-point of closing bid and ask quotes. Using returns for about 160,000 at-the-money delta-hedged option positions initially about one and half months from maturity (and held to maturity) for over 5,000 underlying stocks during 1996-2006, they conclude that: Keep Reading

Turn-of-the-Month Effect and Option Strategy Losses

The Strategy Test presently focuses on iteratively selling put options on the Russell 2000 Index with less than one month to expiration to capture the volatility risk premium. The test strategy seeks to exploit the turn-of-the-month (TOTM) effect to enhance this capture. Are there characteristics of index returns from options expiration (OE) to TOTM, during TOTM and from TOTM to OE that might inform options moneyness and position adjustment decisions? Using daily opening and closing levels of the Russell 2000 Index over the period September 1987 through April 2009 (259 complete months), we find that: Keep Reading

Options Detrimental to Individual Investor Health?

Do individual investors who trade equity options do better or worse than those who do not? In their October 2008 paper entitled “Option Trading and Individual Investor Performance”, Rob Bauer, Mathijs Cosemans and Piet Eichholtz examine the impact of option trading on individual investor performance. Using all daily trades and end-of-month portfolio positions for 68,146 individual Dutch investors (41,880 who trade equities only and 26,266 who trade options at least once) over the period January 2000 to March 2006, they conclude that: Keep Reading

Actual Index Options Trading Results

What kinds of returns do options traders actually achieve? In their January 2009 paper entitled “Investor Trading Behavior and Performances: Evidence from Taiwan Stock Index Options”, Bing Han, Yi-Tsung Lee and Yu-Jane Liu examine trading behavior and net returns for all traders of Taiwan stock index options. Using the complete record of transactions, orders and quotes for Taiwan stock index options during 2002-2005 (involving 238,303 individual investors, 1,076 domestic institutions, 50 foreign institutions and 29 market makers), they conclude that: Keep Reading

Collaring a Broad Equity ETF for Stable Returns?

Does a long options collar effectively hedge a broad equity exchange-traded fund (ETF), protecting against the downside while capturing a reasonable upside? In their April 2008 paper entitled “Collaring the Cube: Protection Options for a QQQ ETF Portfolio”, Edward Szado and Hossein Kazemi examine the risk-return characteristics of a passive (mechanical, no market timing) long collar strategy on the Powershares QQQ trust ETF (QQQQ), including transaction costs. A collar consists of a put option position to protect an underlying long equity position, combined with covered call options on the same underlying to fund the puts (thereby limiting upside potential). The authors consider 27 different collar combinations by varying moneyness of the puts and calls (5% out-of-the-money, 2% out-of-the-money and at-the-money) and the initial time to maturity of the puts (one, three and six months). Initial time to maturity for calls is always one month. Using daily closing prices for QQQQ and the selected put and call options over the period March 1999 to March 2008 (108 months), they conclude that: Keep Reading

Correlation Variability as Driver of the Volatility Risk Premium

Correlations among asset returns vary over time, introducing risk to the benefits of diversification. Intervals of extraordinarily high correlation amplify marketwide volatility and are disruptive to asset allocation policies. Does the risk of such correlation shocks explain the volatility risk premium associated with marketwide (equity index) options? In the July 2008 version of their paper entitled “The Price of Correlation Risk: Evidence from Equity Options”, Joost Driessen, Pascal Maenhout and Grigory Vilkov examine how correlation shocks affect the returns of options for a broad stock index and of options for its individual component stocks. Using daily returns for the S&P 100 index, its components and associated options over the period 1996-2003, they conclude that: Keep Reading

The Why of the Volatility Risk Premium

Why does the volatility of the stock market as implied by the prices of equity index options generally exceed actual (realized) volatility, thereby indicating large returns for sellers of index options? Is the reward of selling such options commensurate with the risk? In the June 2008 version of his paper entitled “The Volatility Premium”, Bjorn Eraker models the volatility risk premium based on the long-run effects of small (normal diffusion) and large (non-normal jumps) shocks to volatility. Using daily returns for the S&P 500 index and daily levels of the CBOE Volatility Index (VIX) over the period 1990-2007, he concludes that: Keep Reading

Effect of Stock Market Momentum on Index Options Prices

Do stock index option prices incorporate stock market price momentum, an expectation of continuation of a recent market trend? In their 2004 journal article entitled “Index Option Prices and Stock Market Momentum”, Kaushik Amin, Joshua Coval and Nejat Seyhun test the dependence of broad equity market index option prices on past market returns. Using price data for S&P 100 index (OEX) options for the period 1983-1995, they conclude that: Keep Reading

Volatility Premium and the Four Factors

Does the volatility risk premium, the difference between options-implied volatility and future realized (actual) volatility, vary systematically with the four most widely used equity risk factors (market, size, book-to-market and momentum)? In other words, might the four factors point to pockets of underpriced or overpriced options? In their November 2008 paper entitled “Implied and Realized Volatility in the Cross-Section of Equity Options”, Manuel Ammann, David Skovmand and Michael Verhofen investigate the factor dependence of the volatility premium for U.S. equities. Using a sample of all U.S. equity at-the-money call options 91 days from expiration over the period January 1996 through April 2006, along with associated stock price and firm fundamentals data, they conclude that: Keep Reading

Returns for Call Options on Individual Stocks

Are out-of-the-money (OTM) call options a good way to speculate on spikes in the price of underlying stocks? In other words, are such options reliably underpriced or overpriced? In her August 2008 paper entitled “Stock Option Returns: A Puzzle”, Sophie Xiaoyan Ni investigates one-month returns for call options on individual stocks that do not have an ex-dividend day prior to expiration. Using expiration date option price data for a broad sample of qualifying stocks during January 1996 through June 2005, she concludes that: Keep Reading

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