Stock Return Predictability of Out-of-the-Money Option Trading

Abstract

This paper provides evidence of the market segmentation of stock and options. We find that informed out-of-the money (OTM) option trading measure, which is publicly available, predicts the returns of underlying stock and its at-the-money (ATM) options, but not the returns of OTM options. Specifically, higher OTM put-call trading volume ratio predicts negative returns of stock and ATM calls while predicting positive returns of ATM puts. The results are robust in large stock and not driven by short-selling costs. Using the OTM put-call volume ratio, we propose an implementable investment strategy that offers 20 bp weekly risk-adjusted stock returns (i.e., about 10% annually). Our findings support the segmentation between stock and option markets and between the option contracts in the same class.