TAILIEUCHUNG - OPTION VOLUME AND STOCK PRICES: EVIDENCE ON WHERE INFORMED TRADERS TRADE

As for the effect of macroeconomic variables such as money supply and interest rate on stock prices, the efficient market hypothesis suggests that competition among the profit-maximizing investors in an efficient market will ensure that all the relevant information currently known about changes in macroeconomic variables are fully reflected in current stock prices, so that investors will not be able to earn abnormal profit through prediction of the future stock market movements (Chong and Koh 2003). Therefore, since investment advisors would not be able to help investors earn above-average returns consistently, except through access to and employing insider information,. | THE JOURNAL OF FINANCE VOL LIII NO. 2 APRIL 1998 Option Volume and Stock Prices Evidence on Where Informed Traders Trade DAVID EASLEY MAUREEN O HARA and P. S. SRINIVAS ABSTRACT This paper investigates the informational role of transactions volume in options markets. We develop an asymmetric information model in which informed traders may trade in option or equity markets. We show conditions under which informed traders trade options and we investigate the implications of this for the linkage between markets. Our model predicts an important informational role for the volume of particular types of option trades. We empirically test our model s hypotheses with intraday option data. Our main empirical result is that negative and positive option volumes contain information about future stock prices. The information content of trading activity is a subject of widespread interest. If trades are correlated with private information then the outcome of the transaction process may portend future movements in price. The extension of trading to different venues or to derivative instruments however means that this link between transactions and information need not be easily discernible. If there are alternative markets in which informed traders can profit from their information then where informed traders choose to trade may have important implications not only for security price movements but for the behavior of related prices as well. This suggests that transactions in derivative markets may be an important predictor of future security price movements. In this paper we investigate the informational role of transactions volume in options markets. For some readers this focus may seem puzzling an option is a derivative security so its price should be dictated unilaterally by the behavior of the stock price. This unidirectional linkage is only true however in complete markets if information is impounded into prices by trading then the ability of informed traders to transact in .

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