It seems that a large part of the time, they do. A new study has revealed that a portfolio on the basis of preferences of options traders has consistently beaten the overall stock market. In reaching that conclusion, the study paves the way for what may constitute a very profitable stock-picking strategy.
The study,’ The Information in Option Volume for Future Stock Prices,’ is listed in the fall 2006 issue of the Review of Financial Studies. Its authors are two associate professors of finance: Jun Pan of the Sloan School of Management at the Massachusetts Institute of Technology and Allen M. Poteshman of the University of Illinois at Urbana-Champaign.
Because of the way options are designed, traders have powerful incentives to go to the options market once they have information that is likely to have an impact on a stock’s price, Professor Poteshman said. A call option, for example, which amounts to a bet that a stock’s price will rise, enables its owner to buy that stock at a preset level. If, by the time of the option’s expiration, the stock trades above that level, the option may be worth several times what was pay for it; if not, it will be worthless. In other words, the option has much leverage. A small percentage shift in the price of the underlying stock can mean a gap of hundreds of percentage points in the option’s profitability, as a result.
Definitely things to be considered.
Similar risks and rewards exist for put options. These are bets that a stock’s price will fall. Puts enable their owners to sell that stock at a preset level, and he’ll be worth an increasingly large amount if the stock trades below that level by the time that put expires. If not, the put will be worthless.
Have specific guidelines meant for entering a trade. Know what is going to cause you to be enter a trade. Is it a specified technical analysis indicator or a fundamental assessment of the firm. Whatever it is, stick to it. Don’t enter a exchange for other reasons, especially not because a friend told you about several company. If it does not connect with your criteria, stay far from the idea.
Here’s A Few More Ideas
Until now, there has been no comprehensive study of option traders’ track records as stock pickers. That has not been for lack of trying: the required data simply was not accessible to researchers. The volume figures that options exchanges report publicly, for example, reflect a mixture of several kinds of transactions, muddying the overall picture. The volume number reported for a particular option, for example, may reflect new purchases by options traders, but it may also include the sale of positions previously acquired. That makes it hard to say whether traders actually favored a stock.
Using a private database provided by the Chicago Board Options Exchange, the two professors were able to deconstruct an option’s total trading volume into various categories. They excluded trades by market makers, for example– dealers at the options exchange who buy and sell securities for the overall goal of maintaining liquidity. They narrowed the database further to concentrate on just that portion of an option’s daily trading volume that reflected new positions by other traders, on the basis that these transactions offered a clearer signal of what traders actually thought of the underlying stock. The database covered the dozen years since the onset of 1990 through the ending of 2001.
The professors calculated a daily volume ratio of newly acquired put options to newly acquired call options, for each option in this database. A high ratio meant a strong consensus among options traders that the price of the option’s underlying stock would fall, while a low ratio showed a widely shared hope that the stock would rise. The professors found that the stocks whose options had the lowest ratios consistently outperformed the stocks whose options had the highest ratios.
The professors reported that before transaction costs, this portfolio produced an annual average return of 62 percent over the dozen years referred to in the study. This contrasts with an annualized total return of 12.3 percent for the big stock market over this period, as measured by the Dow Jones Wilshire 5000 index. Still more impressive was the very fact that the portfolio earned double-digit returns each year, even though the overall market declined. Based on their data, however, the professors had no way to determine how options traders were able to obtain these results.
The portfolio required frequent transactions because the price moves correctly anticipated by options traders lasted for only a few weeks, on average. So transaction costs would have eaten up a big chunk of the return. But Professor Poteshman estimated that in the possession of an institutional investor, for whom such costs would typically be quite low, the portfolio’s return would still have been as much as 50 percent annually.
Even for individual investors, who would pay higher costs, Professor Poteshman estimated that the annualized return is said to have been well into double digits.
DESPITE the strong findings of the strategy, it would’ve no more than academic interest if investors had no access to the private C.B.O.E. Database that the professors studied. In July, however, the exchange began selling subscriptions to this database to the public.
A subscription is not cheap: $600 a month. That helps make the professors’ strategy impractical for small investors. Still, the study shows that potentially valuable information can be obtained in options traders’ behavior. And institutional investors, including hedge funds and mutual funds, can easily exploit it.
A portfolio built on buying stocks that options traders like, and shorting those they do not, has been demonstrated to beat the market handily.
The portfolio is rebalanced weekly to hold the 20 percent of stocks with the lowest ratios of newly acquired put options to call options and to short the 20 percent of stocks with the largest ratios. Return excludes transaction costs.