Abstract
Informed traders may prefer the options market to the stock market for reasons including the leverage effect, transaction costs, restrictions on short sale. Many studies try to predict future returns of stocks using informed traders' behavior in the options market. In this study, we examine whether the trading volume ratios of single stock options have the predictive power for future returns of the underlying stock. By analyzing the stock price responses to the “preliminary announcement of performance” of 36 underlying stocks on the Korea Exchange from November 2014 to March 2021 and the trading volume of options written on those stocks, we investigate the relation between the option ratios, which are the call option volume to put option volume ratio (C/P ratio) and the option volume to stock volume ratio (O/S ratio), and the future returns of the underlying stock. We also examine which ratio is better in predicting the future returns. The authors found that both option ratios showed the statistically significant predictability about future returns of the underlying stock and that the return predictability of the O/S ratio is more robust than that of the C/P ratio. This study shows that indicators generated in the options market can be used to predict future underlying stock returns. Further, the findings of this study contributed to a dearth of literature pertaining to single stock options. The results suggest that the single stock options market is efficient and influences the price discovery in the stock market.
Highlights
Informed traders might be induced to trade options rather than stocks since the option market is known to provide more opportunities of leverage (Black, 1975)
Korea Exchange, from November 2014 to March 2021, we examine the relation between option ratios and future returns of stocks
3.2 Methodology The purpose of this study is to find whether the C/P ratio and the O/S ratio can predict the future returns of the corresponding underlying asset, and to compare the predictive power of the two ratios
Summary
Informed traders might be induced to trade options rather than stocks since the option market is known to provide more opportunities of leverage (Black, 1975). The existence of informed traders in the options market is supported by evidence that the trading volume of options increases around the announcement of favorable or unfavorable news. The call option trading volume of takeover targets increases just before the announcement date (Cao et al, 2005). The net trading volume of put option increases a few days prior to negative earnings announcements (Hao et al, 2013). If informed traders are active in the options market, the future return of a stock may be predicted by the trading volume of options, which have the corresponding stock as their underlying asset. Two of the widely used measures referenced in the literature are the ratio of trading volume of call option to that of put option (C/P ratio, hereafter) and the ratio of trading volume of both call and put options to that of an underlying stock (O/S ratio, hereafter)
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