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Aggregate Stock Option Put-Call Ratio as Market Return Predictor

Posted in Equity Options, Equity Premium

Do aggregate positions in put and call options on individual stocks, as indicators of sentiment of informed traders, predict future market returns? In their July 2017 paper entitled "Stock Return Predictability: Consider Your Open Options", Farhang Farazmand and Andre de Souza examine the power of average value-weighted put option open interest divided by average value-weighted call option open interest in individual U.S. stocks (PC-OI) to predict U.S. stock market returns. Specifically, they:

  • Compute for each stock each day total put option open interest and total call option open interest.
  • Average daily values for each stock by month and weight by market capitalization.
  • Calculate PC-OI by dividing the sum of monthly capitalization-weighted average put option open interest by the sum of monthly capitalization-weighted call option open interest.
  • Each month, relate via regression monthly PC-OI to stock market return the next three months to determine the sign of the future return coefficient.
  • Each month, create a net signal from the sum of the signs of these coefficients from the last three monthly regressions. A positive (negative) sum indicates a long (short) position in the stock market and an offsetting short (long) position in the risk-free asset.

They further test whether PC-OI predictive power concentrates in stocks with unique informativeness as represented by high idiosyncratic volatility (individual stock return volatility unexplained via regression versus market returns). For comparison, they also test their model with S&P 500 index options. Using daily open interest for options on AMEX, NYSE and NASDAQ common stocks and on the S&P 500 Index with moneyness 0.8-1.2 and maturities 30-90 days, associated stock characteristics, and contemporaneous U.S. stock market returns during January 1996 through August 2014, they find that:

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