Informed Trading in the Options Market and Stock Return Predictability

Informed traders often use options that are not in‐the‐money due to higher potential gains for a smaller upfront cost. Thus, trading activity by option moneyness should be a gauge of informed option trading. We construct a dollar volume‐weighted average moneyness measure to capture option trading activity at different moneyness levels. Stock returns increase with this measure, suggesting more trading activity in options with higher leverage predicts future stock returns. Our results hold cross‐sectionally and at the portfolio level yielding a Fama–French five‐factor α of 12% per year for all stocks and 33% per year for high implied volatility stocks.

mentioning

confidence: 99%

Show me the money: Option moneyness concentration and future stock returns

Bergsma

Csapi

Diavatopoulos

et al. 2019

“…Directional trading is another prime trading motive in the options market, though it distorts options prices (e.g., put‐call parity violation) and adds significant noise to implied volatility (Cremers & Weinbaum, 2010; Easley et al, 1998). The notion that directional traders move away from the options market during periods of high uncertainty has both theoretical (Capelle‐Blancard, 2001) and empirical support (Chakravarty et al, 2004; Han et al, 2017). In particular, Capelle‐Blancard's (2001) model shows that the inflow of volatility‐informed traders increases the bid‐ask spread in the options market, which drives directional traders out of the options market.…”

Section: Empirical Analysesmentioning

confidence: 99%

“…Directional trading is another prime trading strategy in the options market that distorts options prices (e.g., put‐call parity violation) and adds significant noise to implied volatility (Cremers & Weinbaum, 2010; Easley, O'Hara, & Srinivas, 1998). Both theoretical (Capelle‐Blancard, 2001) and empirical works (Chakravarty, Gulen, & Mayhew, 2004; Han, Kim, & Byun, 2017) support the notion that directional traders move away from the options market during periods of high uncertainty. In sum, under high uncertainty, implied volatility is largely determined by volatility‐informed traders (rather than directional traders), which makes it highly informative of future volatility.…”

Section: Introductionmentioning

confidence: 99%

Uncertainty and the volatility forecasting power of option‐implied volatility

Jeon

Seo

Kim

2020

This study investigates the impact of uncertainty on the volatility forecasting power of option-implied volatility. Option-implied volatility is a powerful predictor of future volatility, particularly during periods of high uncertainty. This is consistent with option-implied volatility being largely determined by volatility-informed traders (rather than directional traders) when uncertainty is high. New volatility forecasting models that incorporate such interaction outperform benchmark models, both in-and out-of-sample. The new models also better predict future volatility during the 2008 global financial crisis, for which benchmark models perform poorly. The results are robust to alternative choices of benchmark models, loss functions, and estimation windows.

Return predictability and contrarian profits of international index futures

Tse

2017

Using futures markets, we examine the lead‐lag relationships among 11 industrialized countries. Lagged monthly returns for several countries have return predictability comparable to those in the United States for the 1988–2016 period. The international futures markets are more correlated in market downturns, while the lead‐lag relationships are more significant in market upturns. Consistent with these asymmetric relationships, a contrarian strategy (in particular, by buying the losers) offers significant profits in an up market but not in a down market. The contrarian profits are not captured by a factor model using global equity factors and momentum profits.