TAILIEUCHUNG - The Information in Option Volume for Future Stock Prices

In conventional rational asset-pricing models with common priors—even those that allow for asymmetries in information across traders (Grossman and Stiglitz, 1980; Kyle, 1985)—the volume of trade is approximately pinned down by the unanticipated liquidity and portfolio rebalancing needs of investors. However, these motives would seem to be far too small to account for the tens of trillions of dollars of trade observed in the real world. This dissonance has led even the most ardent defenders of the traditional pricing models to acknowledge that the bulk of volume must come from something else—for example, differences. | The Information in Option Volume for Future Stock Prices Jun Pan MIT Sloan School of Management and NBER Allen M. Poteshman University of Illinois at Urbana-Champaign We present strong evidence that option trading volume contains information about future stock prices. Taking advantage of a unique data set we construct put-call ratios from option volume initiated by buyers to open new positions. Stocks with low put-call ratios outperform stocks with high put-call ratios by more than 40 basis points on the next day and more than 1 over the next week. Partitioning our option signals into components that are publicly and nonpublicly observable we find that the economic source of this predictability is nonpublic information possessed by option traders rather than market inefficiency. We also find greater predictability for stocks with higher concentrations of informed traders and from option contracts with greater leverage. This article examines the informational content of option trading for future movements in underlying stock prices. This topic addresses the fundamental economic question of how information gets incorporated into asset prices and is also of obvious practical interest. Our main goals are to establish the presence of informed trading in the option market and also to explore several key issues regarding its nature. Our focus on the informational role of derivatives comes at a time when derivatives play an increasingly important role in financial markets. Indeed for the past several decades the capital markets have experienced an impressive proliferation of derivative securities ranging from equity options to fixed-income derivatives to more recently credit derivatives. We thank Joe Levin Eileen Smith and Dick Thaler for assistance with the data used in this article and Harrison Hong and Joe Chen for valuable initial discussions. We are grateful for the extensive comments and suggestions of an anonymous referee and the comments of Michael Brandt Darrell .

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