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

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Trading on the Information Content of Open Interest: Evidence from the US Equity Options Market Trading on the information content of open interest: Evidence from the US equity options market Rafiqul Bhuyan* and Mo Chaudhury *Department of Management, College of Business Administration, California State University, 6000 J Street, Sacramento, CA 95819-6088, USA. Tel: ϩ1 916 278 6459; E-mail: [email protected] Received (in revised form): 5th January, 2005 Rafiqul Bhuyan is an assistant professor of finance at California State University, Sacramento, CA, USA. Prior to joining California State University, he was affiliated with Midwestern State University, University of Dhaka, Concordia University, North South University and Thompson River University. Dr Bhuyan has written several papers, presented papers at several international conferences in finance, and has served as a finance consultant. He holds a PhD degree in economics from Concordia University, Canada, and an MSc in finance from the University of Illinois at Urbana-Champaign, USA. Dr Bhuyan’s research interests are options and futures, information economics and empirical finance. Mo Chaudhury PhD, is a faculty lecturer in finance at McGill University, Canada. He was Principal Economist, Single Family Portfolio Management at the US mortgage giant Freddie Mac; Associate Professor of Finance, University of Saskatchewan, Canada; and had visiting appointments at McGill University, Canada, and Southern Methodist University, USA. He has taught in various international and executive programmes in Canada, Japan and China, and his research — primarily in the area of derivatives — has appeared in various reputable journals. Practical applications This research designs and then empirically tests trading strategies based on information implicit in the distribution of open interests across various strike prices of equity call and put options. The results suggest that the open-interest based trading strategies have the potential to generate enhanced trading returns or lower trading losses. Accordingly, investors should watch for information implicit not just in option prices but also in option market activity. Abstract distribution of options open interest. Several stock This paper uses daily closing data on Chicago only and stock plus options directional trading Board of Options Exchange (CBOE) options of strategies are then considered after comparing the 30 stocks during February to July, 1999, to predicted stock price at maturity and the actual investigate whether options open interest contains stock price at the trade initiation date. In the Derivatives Use, Trading & Regulation, information that can be used for trading sample, these trading strategies generate better Vol. 11 No. 1, 2005, pp. 16–36 purposes. Individual stock price at option returns compared with the S&P500, the buy ᭧ Henry Stewart Publications, maturity is first predicted based on the and hold strategy involving the sample stocks 1747–4426 16 Derivatives Use, Trading & Regulation Volume Eleven Number One 2005 and the Merton et al. (1978, ‘The Returns and market makers interact in the asset market. Risk of Alternative Call Option Portfolio In an asymmetric information environment, Investment Strategies’, Journal of Business, informed traders may profit at the cost of Vol. 51, pp. 183–242) style covered call noise or liquidity traders’ losses.1 Continued strategy. The empirical evidence thus indicates trading by the informed investors can, that non-price measures of activity in the however, serve as a signal to the other derivatives market — such as open interest — (uninformed) market participants who can contain information about the future level of the learn the underlying information in a underlying asset. This lends support to prior Bayesian fashion and trade accordingly.2–4 works which suggest that derivatives cannot be Although the implications for the price considered as redundant in a market with paths, volume changes and trading strategies information-related frictions. One implication is are different, information-motivated trading that the distribution of non-price derivatives may also be driven by differential market activity may be helpful for other purposes information5 or differential interpretation of where the physical instead of the risk-neutral the same information6 by informed traders. distribution of the underlying asset is needed. With the introduction of the options These include beta estimation, volatility market, informed traders as well as liquidity forecasting and volatility trading. traders have an additional means of meeting their trading needs. In fact, informed traders may find the options market more lucrative INTRODUCTION than the stock market, owing to lower Derivative securities are considered as transaction costs, lesser capital outlay, higher additional means for informed traders to leverage, limited loss potential and fewer trade on their information and for others to trading restrictions, (eg no up tick rule for discover that information. Derivatives may shorting).7 not only lead the underlying assets in If informed traders do choose to trade in imparting information, they may also the options market, not only do option provide information that simply cannot be prices and options market activity become inferred from the markets in underlying relevant in imparting the information and assets. This paper examines the role of its subsequent discovery, options could, in options market open interest in conveying fact, lead the underlying stock in terms of information about the future movement of price change and trading activity. Grossman8 the underlying asset. This study shows that suggests that underasymmetric information the activity in the equity options market traded derivatives are not the same as their seems to contain information about future synthetic counterparts owing to their stock price that can be exploited for trading differential information content. While purposes. Financial economists have long Detemple and Selden9 argue that been interested in the process of price information asymmetry may alter the formation when informed traders, hedging opportunities and, as such, affect uninformed liquidity (or noise) traders and the underlying asset price, Back et al.10 Bhuyan and Chaudhury 17 examine the impact on option prices. Biais uninformed or liquidity traders. Mayhew et and Hillion11 show that the price volatility al.21 find that a reduced equity options of the underlying asset may be affected by writing margin increases the bid–ask spread information asymmetry. Brennan and Cao12, of the optioned stocks and that the by contrast, show that in a noisy rational uninformed traders are more liquidity expectations equilibrium, option trades may constrained than the informed traders. not be information based. An impressive While much attention has been paid to literature has emerged researching this and the information content of derivative prices, other related issues, although the empirical theoretical research on the information evidence appears inconclusive. Using the content of derivatives market activity about Black–Scholes model, Manaster and the future movement of the underlying Rendleman13 find support for the asset is only beginning to emerge. The incremental information content of options general equilibrium analysis of Leisen and based on returns from ex post and ex ante Judd22 provides insights into how open trading strategies. Using the Berkley interests are determined along with the transaction data on options, Bhattacharya14 option prices for various strikes in an also finds incremental information content incomplete market setting. In their paper, of options, although the trading benefits agents have heterogeneous risk preferences seem marginal. Vijh15 questions the ex post but homogeneous probability beliefs about results based on daily closing prices owing the underlying assets. As such, derivatives to the bias arising from the market activity (the distribution of open non-synchronicity of closing stock and interests) is not informative about the future option trades and the bid–ask bounce. of the risky asset. This line of research is Anthony16 uses volumes of options mainly due to Easley et al.23 In their bracketing the daily closing price and finds empirical study of 50 stocks with the most that, for 64 per cent of the sample stocks, actively traded options on the Chicago the options volume led the stock volume in Board of Option Exchange (CBOE) during a Granger Causality sense. About 48 per October and November of 1990, Easley et cent of cases, however, are statistically al.23 find that the volume of directional significant in both univariate and option trades indeed leads the stock price multivariate causality tests. Stephan and changes, although the total option volume Whaley17, by contrast, find stocks to lead has no such predictive power. This shows their options in terms of both intra-day that the pattern of derivatives market price change and trading activity. Sheikh activity may contain information about the and Ronn18 attribute unique patterns of future movement of the underlying asset. returns in the options market to The contribution of this paper can be information-based trading there. John et summarised as follows. First, this study al.19,20 show that the impact of options examines the information content of the trading depends on the margin and liquidity distribution of options open interest. It uses constraints faced by the informed and the discrete distribution of equity option 18 Bhuyan and Chaudhury open interest across various strike prices as
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