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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.

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

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

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