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The Option to Stock Volume Ratio and Future Returns

Last Updated on 10 February, 2024 by Rejaul Karim

Dive into the complex world of financial markets with “The Option to Stock Volume Ratio and Future Returns,” an in-depth analysis by Travis L. Johnson and Eric C. So. Featured in the Journal of Financial Economics, this 61-page study, taking place in November 2012, examines the intricate interactions between option and stock volumes when the direction of a trade is unclear.

Employing a multimarket symmetric information model, the authors decode the negative link between relative option volume and future company value, a relationship impacted by short-sale costs. Their experiments show that companies with the lowest option to stock volume ratio (O/S) surpass others by a monthly 1.47% on a risk-adjusted basis.

Learn how O/S proves to be a significant predictor, especially in situations of high short-sale costs or low option leverage. It forecasts future company-specific earnings news and reflects the sophistication of private information within financial ecosystems.

Abstract Of Paper

We examine the information content of option and equity volumes when trade direction is unobserved. In a multimarket symmetric information model, we show that equity short-sale costs result in a negative relation between relative option volume and future firm value. In our empirical tests, firms in the lowest decile of the option to stock volume ratio (O/S) outperform the highest decile by 1.47% per month on a risk-adjusted basis. Our model and empirics both indicate that O/S is a stronger signal when short-sale costs are high or option leverage is low. O/S also predicts future firm-specific earnings news, consistent with O/S reflecting private information.

Original paper – Download PDF

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Author

Travis L. Johnson
The University of Texas at Austin

Eric C. So
Massachusetts Institute of Technology (MIT) – Sloan School of Management

Conclusion

In unraveling the intricate dynamics of option and equity volumes, Johnson and So unveil a compelling narrative of predictive power. Their multimarket symmetric information model elegantly elucidates the negative correlation between the option to stock volume ratio (O/S) and future firm value, accentuated by equity short-sale costs.

Empirical validation showcases firms in the lowest O/S decile outperforming their counterparts by a notable 1.47% per month, underlining O/S as a potent risk-adjusted signal. Significantly, this predictive prowess amplifies in conditions of heightened short-sale costs or diminished option leverage.

Beyond mere volume metrics, O/S emerges as a harbinger of future firm-specific earnings news, offering a nuanced lens into the landscape where private information subtly shapes market trajectories.

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FAQ

Q1: What is the main focus of the research conducted by Travis L. Johnson and Eric C. So in “The Option to Stock Volume Ratio and Future Returns”?

A1: The research focuses on examining the information content of option and equity volumes in situations where the direction of trade is unobserved. The authors utilize a multimarket symmetric information model to decode the negative relationship between the option to stock volume ratio (O/S) and future firm value, particularly influenced by equity short-sale costs.

Q2: How does the option to stock volume ratio (O/S) serve as a predictor in the study, and what are the key findings?

A2: Empirical tests in the study reveal that firms in the lowest decile of the O/S outperform those in the highest decile by 1.47% per month on a risk-adjusted basis. The O/S proves to be a stronger signal when short-sale costs are high or option leverage is low. The research establishes O/S as a significant predictor, especially in situations with elevated short-sale costs, highlighting its value as a risk-adjusted signal.

Q3: What additional insights does the research provide regarding the predictive power of O/S, and how does it relate to future firm-specific earnings news?

A3: The research indicates that the O/S serves as a predictor of future firm-specific earnings news, suggesting that it reflects private information within financial ecosystems. Beyond predicting future stock returns, O/S offers insights into the landscape where private information subtly shapes market trajectories, showcasing its relevance in understanding the dynamics of financial markets.

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