The Information in Option Volume for Future Stock Prices (Pan & Poteshman (2006))

The Information in Option Volume for Future Stock Prices

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What they found

Using CBOE data that identifies whether option trades open new positions and whether the trader is a customer or a firm, the authors built a put-call volume ratio from opening buys only and tested whether it predicts stock returns. Stocks with low put-call ratios (relatively more call buying) outperformed those with high ratios by about 40 basis points the next day and 1% over the next week, with the effect strongest for small-investor, non-public options trades, suggesting these traders had private information. The predictability lasted several weeks and was not arbitraged away.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Buying a call: payoff at expiry. A 105-strike call bought for 3 loses that whole 3 if the price finishes at or below 105, breaks even at 108, then gains a dollar for every dollar higher. The loss is capped at the premium; the upside is not capped.

What you can use

Opening option volume, particularly from non-market-maker customers, contains information about the stock's near-term direction.
The signal is in newly opened positions, not raw volume; aggregate put-call ratios are much noisier.
Informed traders use options for leverage, so unusual call buying before news is a documented phenomenon.

Caveats

Requires proprietary CBOE open/close data not available to retail in the same form. Sample 1990 to 2001. The one-day effect is smaller than typical retail trading costs.

Tags: options, option-volume, informed-trading, put-call-ratio

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.