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Using OTM Equity Options Volume to Predict Stock Returns

| | Posted in: Equity Options

Does trading of out-of-the-money (OTM) equity options expose exploitable private information? In their July 2016 paper entitled “Stock Return Predictability of Out-of-the-Money Option Trading”, Chang Mo Kang, Donghyun Kim and Geul Lee investigate relationships between OTM option trading volume and future returns of underlying stocks. They define OTM based on a range of option deltas and normalize OTM volume by dividing by total option volume for a stock. They first test the power of normalized OTM put and call volumes to predict stock returns at a daily frequency. They then test the power of the OTM put-call volume ratio (OTM put volume divided by all OTM option volume) to predict stock returns at daily and weekly frequencies. Finally, they test a hedge strategy that is each week long (short) the ranked tenth, or decile, of stocks with the lowest (highest) prior-week put-call volume ratios. Using daily and weekly data for relatively liquid near-term options and returns for underlying stocks during 1996 through 2015, they find that:

  • Normalized OTM call (put) volume relates positively (negatively) to future stock returns at both daily and weekly measurement frequencies.
  • The OTM put-call ratio relates negatively to future stock returns for up to six trading days.
  • The value-weighted hedge portfolio specified above:
    • Generates a gross weekly return of 0.19% (about 10% annualized).
    • Generates a gross weekly four-factor (market, size, book-to-market and momentum) alpha of 0.20%
    • Outperforms an equal-weighted portfolio, implying that OTM option volume predicts returns for large stocks more accurately than for small stock returns (perhaps indicating that informed investors prefer liquid options).
  • During the month before a takeover announcement, OTM call volume is much higher for takeover targets than for similar firms. An elevated OTM call volume predicts a positive earnings surprise the following week.
  • The predictive power of OTM put volume weakens during 2011-2015, but that of OTM call volume does not.
  • The predictive power of very deep OTM options is weaker than that of moderately OTM options.

In summary, investors may be able to follow the lead of informed OTM option traders via positions in underlying large-capitalization stocks.

Cautions regarding findings include:

  • Reported returns are gross, not net. Trading frictions and shorting costs may preclude exploitation of OTM option signals for many traders.
  • Average weekly return of trades is not sufficient evaluate strategy attractiveness. The strategy may be volatile, and trading opportunities may cluster (complicating capital allocation).
  • Testing different OTM option volume metrics on the same data introduces snooping bias, such that the best-performing metric overstates expectations.
  • There may be additional data snooping in selection of OTM thresholds.

See also “Picking Stocks Based on Option Volume Spikes”.

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