Informed traders and Optons Markets

If you were an informed trader, would you trade in the options market or in the market for the underlying asset? Finance theory says you'd trade in the options market because of increased leverage.

Now here's another paper that supports this idea. In their March 2008 paper Xiaoyan Zhang, Rui Zhao and Yuhang Xing look at whether relatively expensive put options can be used as "bad news" indicators. Here's the abstract of their paper:

The shape of the volatility smirks has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 15% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to buy out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.

Read the whole thing here.

In case you're not familiar with the term, the volatility "smile" refers to the phenomenon that implied volatility increases for options that are further out of the money. If the increase in implied volatility is greater on one side than on the other, the pattern is known as a volatility "smirk". In the case of this paper the smirk is used as an indicator of the degree to which puts or calls are relatively expensive. For example, if calls are relatively more expensive, that is taken as an indicator that informed traders have been buying calls because they have positive information about a stock, with expensive puts being an indicator that traders possess bad news.

In addition to predicting subsequent returns, the authors also find that firms with the most expensive put options are more likely to have the worst negative earnings shocks in the following quarter.

All in all, a pretty cool paper that indicates how information from one market can predict movements in another.

HT: CXO Advisory Group