Option Volume and Stock Prices: Evidence on Where Informed Traders Trade

Abstract

This paper investigates the informational role of transactions volume in options markets. We develop an asymmetric information model in which informed traders may trade in option or equity markets. We show conditions under which informed traders trade options, and we investigate the implications of this for the linkage between markets. Our model predicts an important informational role for the volume of particular types of option trades. We empirically test our model's hypotheses with intraday option data. Our main empirical result is that negative and positive option volumes contain information about future stock prices. THE INFORMATION CONTENT of trading activity is a subject of widespread interest. If trades are correlated with private information, then the outcome of the transaction process may portend future movements in price. The extension of trading to different venues or to derivative instruments, however, means that this link between transactions and information need not be easily discernible. If there are alternative markets in which informed traders can profit from their information, then where informed traders choose to trade may have important implications not only for security price movements, but for the behavior of related prices as well. This suggests that transactions in derivative markets may be an important predictor of future security price movements.In this paper we investigate the informational role of transactions volume in options markets. For some readers, this focus may seem puzzling; an option is a derivative security so its price should be dictated unilaterally by the behavior of the stock price. This unidirectional linkage is only true, however, in complete markets; if information is impounded into prices by trading, then the ability of informed traders to transact in options markets means

The bright side of financial derivatives: Options trading and firm innovation

“…Apart from reducing information asymmetry, Black (1975) notes that informed traders could use options markets as an alternative venue for trading because option contracts provide higher leverage. Easley, O'Hara, and Srinivas (1998) argue that options can be more attractive for informed traders because the availability of multiple contracts confronts uninformed traders with substantial challenges. In a similar vein, Cao (1999) suggests that agents with private information should be able to trade more effectively on their information in the presence of options, thus improving price informativeness.…”

The Information Content of Option Prices: Evidence from S&P 500 Index Options

“…We find firstly that the previous finding (Black, 1975;Easley et al, 1998) that informed traders prefer options to stocks and are willing to make profits by trading options instead of stocks, still holds in the S&P 500 index option market. Secondly, volatility curvatures extracted from the implied volatility functions and skewness premiums extracted from the risk-neutral probability density respectively are found to possess valuable information on the market direction, which sup-1) Although there is a distinction between long term and short term trading for a corporate trader, we set '60/40' principle for individual trader.…”

“…Black (1975) and Easley, O'Hara and Srinivas (1998) argue that an informed trader would prefer to trade options to stocks because of options' leverage effect. Manaster and Rendleman (1982), Bhattacharya (1987), Amin and Lee (1997), Chan, Chung, and Fong (2002), Cao, Chen and Griffin (2005) and Pan and Poteshman (2006) find that some informed trades on options achieve excess rates of return and that option market quotes contain information about future stock returns.…”

Information embedded in the trading volume of currency options

“…After Anthony 1 showed the interrelation of stock and option market trading-volume, Easley et al 2 rejected the hypothesis that option volume contains no information about future spot prices. In their empirical study, the latter authors show that past option volumes have information content.…”

“…Thus, Equation (2) does not add much to Equation (1) and is estimated in accordance with previous studies. Since Easley et al 2 found a significant effect of the total volume of trade (puts and calls together) on the price of stocks, it was chosen as an explanatory variable in Equation (2). An econometric analysis performed by Simon and Wiggins 9 tried to examine the predictive power of PCR together with other sentiment indicators.…”