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J. Pan and A.M. Poteshman, “The Information in Option Volume for Stock Prices,” (Seminar paper, MIT Sloan School of Business and University of Illinois at Urbana-Champaign, 13 January 2003.

J. Pan and A.M. Poteshman, “The Information in Option Volume for Stock Prices,” (Seminar paper, MIT Sloan School of Business and University of Illinois at Urbana-Champaign, 13 January 2003.

Abstract: We find strong evidence that option trading volume contains information about future stock price movements. Taking advantage of a unique dataset from the ChicagoBoard Options Exchange, we construct put to call ratios for underlying stocks, using volume initiated by buyers to open new option positions. Performing daily cross-sectional analyses from 1990 to 2001, we find that buying stocks with low put/call ratios and selling stocks with high put/call ratios generates an expected return of 40basis points per day and 1 percent per week. This result is present during each year of our sample period, and is not affected by the exclusion of earnings announcement windows. Moreover, the result is stronger for smaller stocks, indicating more informed trading in options on stocks with less efficient information flow. Our analysis also sheds light on the type of investors behind the informed option trading. Specifically,we find that option trading from customers of full service brokers provides the strongest predictability, while that from firm proprietary traders is not informative. Furthermore,our analysis shows that while public customers on average trade in the option market as contrarians – buying fresh new puts on stocks that have done well and calls on stocks that have done poorly, firm proprietary traders exhibit the opposite behavior. Finally,in contrast to the equity option market, we do not find any evidence of informed trading in the index option market.