eThesis - School of Business electronic theses

Market Trends and Trading in Options versus Stocks

PURPOSE OF THE STUDY

Although there is a lot of evidence on impact of market states on investors’ behavior, the majority of studies in the area concentrates on equity markets, while options have received very limited attention. This thesis aims to partially fill this gap. The topic is of particular importance given the recent fast growth of derivatives markets.

In this study, I theoretically and empirically address the question of how do past equity returns affect trading in options compared to stocks. I investigate both informed and uninformed trade. To the best of my knowledge, this thesis is the first academic study on the subject.

DATA

The sample consists of Chicago Board of Options Exchange (CBOE) traded individual stock options associated with New York Stock Exchange (NYSE) traded equity and covers the period from January 1996 to September 2008. The data includes option market’s transactions, stock market’s transactions, and analysts’ forecasts. Option market data is obtained from the OptionMetrics, which is currently the most comprehensive publically available options trading database. Stock market data comes from The Center for Research in Security Prices database (CRSP). Analysts’ forecasts were extracted from Thomson Reuters I/B/E/S database (IBES).

RESULTS

I develop a theoretical model predicting that both trading volume in options versus stocks and option market’s price informativeness increase following stock market gains. In the model, I incorporate the overconfidence mechanism of Gervais and Odean (2001) into the trading framework by Admati and Pfleiderer (1988). Uninformed (liquidity) investors on aggregate hold long positions in equity and, due to a self-attribution bias, become more (over)confident following bull markets. Overconfident liquidity investors prefer to trade in options underestimating risks of leverage and attracted by higher returns it provides. Increased liquidity reduces trading costs and consequently brings more informed traders to option market, which improves its price informativeness.

I also find empirical evidence in support of my theory. In particular, by regressing option-tostock trading ratios on past market returns and controls, I document an increase in option trading volume relatively to stock trading volume following bull markets. The effect is also present in cross-section as there is relatively more trading in options versus stocks for companies which shares had been on their way up.

Additionally, by regressing stock market returns on past options’ volatility skews and controls, I find that option market predicts stock market better after equity market gains, suggesting increased informed trading. However, this effect is insignificant in cross-section of returns.