Volatility Information Trading in the Option Market

Volatility Information Trading in the Option Market

Sophie Xiaoyan Ni, Jun Pan, and Allen M. Poteshman*

March 12, 2007

Abstract

This paper investigates informed trading on stock volatility in the option market. We construct non-market maker net demand for volatility from the trading volume of individual equity options and find that this demand is informative about the future realized volatility of underlying stocks. We also find that the impact of volatility demand on option prices is positive. More importantly, the price impact increases by 40 percent as informational asymmetry about stock volatility intensifies in the days leading up to earnings announcements and diminishes to its normal level soon after the volatility uncertainty is resolved.

* Ni is at the Hong Kong University of Science and Technology and the University of Illinois at Urbana-Champaign, xni@8f7b3c5277232f60ddcca113. Pan is at the MIT Sloan School of Management and NBER, junpan@8f7b3c5277232f60ddcca113. Poteshman is at the University of Illinois at Urbana-Champaign, poteshma@8f7b3c5277232f60ddcca113. We thank Joe Levin, Eileen Smith, and Dick Thaler for assistance with the data used in this paper. We thank Bob Whaley and an anonymous referee for extensive and insightful comments. We also benefited from the comments of Joe Chen, Jun Liu, Neil Pearson, Josh Pollet, Rob Stambaugh (the editor), Dimitri Vayanos, Jiang Wang, and Josh White and seminar participants at the University of British Columbia, the University of Illinois at Urbana-Champaign, the University of Virginia, Vanderbilt University, and the 2006 AFA meetings. Poteshman thanks the Office for Futures and Options Research at the University of Illinois at Urbana-Champaign for financial support. We bear full responsibility for any remaining errors.

The last several decades have witnessed astonishing growth in the market for derivatives. Its current size of $200 trillion is more than 100 times greater than thirty years ago [Stulz (2004)]. Accompanying this impressive growth in size has been an equally impressive growth in variety: the derivatives market now extends to a broad spectrum of risk including equity risk, interest-rate risk, weather risk, and, most recently, credit risk and inflation risk. This phenomenal growth in size and breadth underscores the role of derivatives in financial markets and their economic value. While financial theory has traditionally emphasized the spanning properties of derivatives and their consequent value in improving risk-sharing [Arrow (1964) and Ross (1976)], the role of derivatives as a vehicle for the trading of informed investors has emerged as another important economic function of these securities [Black (1975) and Grossman (1977)].

We contribute to the body of knowledge on the economic value of derivatives by investigating the role of options as a venue for trading on information about future equity volatility. Our focus on informed volatility trading is motivated to a large extent by the fact that equity options are uniquely suited to investors with information about future volatility. Unlike traders with directional information about underlying stock prices who can trade in either the stock or option markets, traders with volatility information can only use non-linear securities such as options. Moreover, while the question of whether traders use options to trade on directional information has been examined in some detail [Stephan and Whaley (1990), Amin and Lee (1997), Easley, O’Hara, and Srinivas (1998), Chan, Chung, and Fong (2002), Chakravarty, Gulen, and Mayhew (2004), Cao, Chen, and Griffin (2005), and Pan and Poteshman (2006)], the analogous question about volatility information trading has not been systematically addressed in the literature.1 Since volatility plays such a central role in both the

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pricing of options and the reasons for trading options, a better understanding of volatility information trading is clearly important.

Our empirical investigation takes advantage of a unique dataset from the Chicago Board Options Exchange (CBOE) that records purchases and sales of put and call options by non-market makers over the 1990-2001 period. For each underlying stock, we construct daily non-market maker net demand for volatility. Motivated by theoretical models of private information trading, particularly those of Kyle (1985) and Back’s (1993) extension of it to a setting that include options, we pursue two strands of empirical investigation to examine the presence of volatility information trading in the option market. First, we investigate the extent to which the volatility demand extracted from the option market predicts the future volatility realized by underlying stocks. Second, we examine the price impact of volatility demand, focusing especially on the time variation of the price impact leading up to earnings announcements when the level of informational asymmetry is high. Both of these strands yield evidence that there is volatility information trading in the option market.

Our first main finding is that option market demand for volatility predicts the future realized volatility of underlying stocks even after controlling for option implied volatility and a number of other variables. The predictability lasts at least one week into the future and is robust to different measures of realized volatility and to controlling for directional information in the option volume. A natural interpretation of this evidence that option volume is informative about future volatility is that investors trade on volatility information in the option market and the information is subsequently reflected in the underlying stocks.

This interpretation is corroborated by two additional results. First, we find that the non-market maker net demand for volatility constructed from open option volume (trades where non- …… 此处隐藏：38791字，全部文档内容请下载后查看。喜欢就下载吧 ……