Trading on the Information Content of Open Interest: Evidence from the US Equity Options Market

Abstract

In this paper, we use daily closing data on CBOE options of 30 stocks during February through July of 1999 to investigate whether options open interest contains information that can be used for trading purposes. Individual stock price at option maturity is first predicted based on the distribution of options open interest. Several stock only and stock plus options directional trading strategies are then considered after comparing the predicted stock price at maturity and the actual stock price at the trade initiation date. In our sample, these trading strategies generate better returns compared to the S&P 500, the buy and hold strategy involving the sample stocks and the Merton et al (1978) style covered call strategy. Our empirical evidence thus indicates that non-price measures of activity in the derivatives market such as the open interest contain information about the future level of the underlying asset. This lends support to prior works (such as Copeland and Galai (1983), and Easley et al (1998)) that suggest that the derivatives cannot be considered redundant in a market with information-related frictions. One implication is that the distribution of non-price derivatives market activity may be helpful for other purposes where the physical instead of the risk-neutral distribution of the underlying asset is needed. These include beta estimation, volatility forecasting and volatility trading.