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Informed Trading of Out-of-the-Money Options and Market Efficiency Analysis

Last Updated on 10 February, 2024 by Rejaul Karim

In the forthcoming research paper, “Informed Trading of Out-of-the-Money Options and Market Efficiency,” authored by Chang Mo Kang, Donghyun Kim, Junyong Kim, and Geul Lee, the focus is on examining stock return predictability using the “out-of-the-money (OTM) put-to-OTM call trading volume ratio” (OTMPC).

The study argues that in the U.S. equity option market, informed investors seldom write OTM options as the leverage effect fails to compensate for transaction costs adequately. Consequently, the OTMPC captures the relative volume of OTM put purchases to OTM call purchases made by informed investors.

The authors reveal that OTMPC predicts future stock returns and corporate news, even after controlling for existing empirical proxies for informed option trading. Moreover, the return predictability offers practical stock portfolio strategies.

This research highlights that market inefficiency can result from uninformed investors’ limited understanding of how transaction costs impact the trading strategies of informed investors.

Abstract Of Paper

We examine stock return predictability of “Out-of-The-Money (OTM) put-to-OTM call trading volume ratio” (OTMPC). Our numerical analysis predicts that, in the U.S. equity option market, informed investors hardly write OTM options because the leverage effect is not sufficient to compensate for transaction costs. OTMPC, thus, captures the informed investors’ OTM put purchase volume relative to their OTM call purchase volume. After controlling for the existing empirical proxies for informed option trading, we find that OTMPC predicts future stock returns and corporate news. The return predictability offers implementable stock portfolio strategies. Our findings suggest that market inefficiency can emerge from uninformed investors’ limited knowledge about how transaction costs influence the trading strategies of informed investors.

Original paper – Download PDF

Here you can download the PDF and original paper of Informed Trading of Out-of-the-Money Options and Market Efficiency.

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Author

Chang Mo Kang
Hanyang University – School of Business

Donghyun Kim
Chung-Ang University

Junyong Kim
University of Wisconsin – Milwaukee – Department of Finance

Geul Lee
Coinplug, Inc.

Conclusion

In conclusion, the research paper titled “Informed Trading of Out-of-the-Money Options and Market Efficiency” by Chang Mo Kang, Donghyun Kim, Junyong Kim, and Geul Lee, makes significant contributions to understanding stock return predictability by examining the out-of-the-money (OTM) put-to-OTM call trading volume ratio (OTMPC).

The authors demonstrate how informed investors’ trading patterns are shaped by leverage effects and transaction costs in the U.S. equity option market. The study finds that OTMPC successfully predicts future stock returns and corporate news, even after accounting for established empirical proxies for informed option trading.

This return predictability facilitates the development of implementable stock portfolio strategies. The findings emphasize that market inefficiencies can arise from uninformed investors’ limited comprehension of the impact of transaction costs on informed investors’ trading strategies.

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FAQ

Q1: What is the main focus of the research paper “Informed Trading of Out-of-the-Money Options and Market Efficiency” by Chang Mo Kang, Donghyun Kim, Junyong Kim, and Geul Lee?

The paper examines stock return predictability using the “Out-of-The-Money put-to-OTM call trading volume ratio” (OTMPC) in the U.S. equity option market. The authors investigate how informed investors’ trading patterns, specifically related to OTM options, can predict future stock returns and corporate news.

Q2: How does the study propose that informed investors behave in the U.S. equity option market, and what is the significance of the OTMPC ratio?

The research suggests that informed investors in the U.S. equity option market are unlikely to write out-of-the-money (OTM) options due to insufficient compensation for transaction costs. The OTMPC ratio captures the relative volume of OTM put purchases to OTM call purchases made by informed investors, providing insight into their trading strategies.

Q3: What are the key findings regarding the predictive power of OTMPC, and what practical implications does it offer for stock portfolio strategies?

The study reveals that OTMPC predicts future stock returns and corporate news, even after considering existing empirical proxies for informed option trading. The return predictability identified through OTMPC contributes to the development of implementable stock portfolio strategies. The findings emphasize that market inefficiencies can arise when uninformed investors have limited awareness of how transaction costs impact the trading strategies of informed investors.

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