Volatility Information Trading in the Option Market

Abstract

This paper investigates informed trading on stock volatility in the option market. We construct non-market maker net demand for volatility from the trading volume of individual equity options and find that this demand is informative about the future realized volatility of underlying stocks. We also find that the impact of volatility demand on option prices is positive. More importantly, the price impact increases by 40% as informational asymmetry about stock volatility intensifies in the days leading up to earnings announcements and diminishes to its normal level soon after the volatility uncertainty is resolved.THE LAST SEVERAL DECADES have witnessed astonishing growth in the market for derivatives. The market's current size of $200 trillion is more than 100 times greater than 30 years ago (Stulz (2004)). Accompanying this impressive growth in size has been an equally impressive growth in variety: The derivatives market now covers a broad spectrum of risk, including equity risk, interest rate risk, weather risk, and, most recently, credit risk and inf lation risk. This phenomenal growth in size and breadth underscores the role of derivatives in financial markets and their economic value. While financial theory has traditionally emphasized the spanning properties of derivatives and their consequent ability to improve risk-sharing (Arrow (1964) and Ross (1976)), the role of derivatives as a vehicle for the trading of informed investors has emerged as another important economic function of these securities (Black (1975) and Grossman (1977)).We contribute to the body of knowledge on the economic value of derivatives by investigating the role of options as a mechanism for trading on information about future equity volatility. Our focus on informed volatility trading is motivated to a large extent by the fact that equity options are uniquely suited to investors with information about future volatility. Unlike traders with * Ni is at the Hong Kong University of Science and Technology. Pan is at the MIT Sloan School of Management and NBER. Poteshman is at the University of Illinois at Urbana-Champaign. We thank Joe Levin, Eileen Smith, and Dick Thaler for assistance with the data used in this paper. We thank Bob Whaley and an anonymous referee for extensive and insightful comments. We also benefited from the comments of Joe Chen, Jun Liu, Neil Pearson, Josh Pollet, Rob Stambaugh (the editor), Dimitri Vayanos, Jiang Wang, Josh White, and seminar participants at the University of British Columbia, the University of Illinois at Urbana-Champaign, the University of Virginia, Vanderbilt University, and the 2006 AFA meetings. Poteshman thanks the Office for Futures and Options Research at the University of Illinois at Urbana-Champaign for financial support. We bear full responsibility for any remaining errors. 1060The Journal of Finance directional information about underlying stock prices who can trade in either the stock or option markets, traders with volatility information can only use nonlinear securities such as...

The bright side of financial derivatives: Options trading and firm innovation

“…In a similar vein, Cao (1999) suggests that agents with private information should be able to trade more effectively on their information in the presence of options, thus improving price informativeness. Moreover, options are a mechanism for trading on information about future equity volatility, which allows investors with information about stock price volatility to benefit from options (Ni, Pan, and Poteshman, 2008). These notions are further supported by Chakravarty, Gulen, and Mayhew (2004) and Pan and Poteshman (2006), who find that options order flows contain information about the future direction of the underlying asset.…”

Predictability and Predictors of Volatility Smirk: A Study on Index Options

“…Moreover, an impressive range of researchers (see Manaster and Rendleman 1982, Chan et al 2002, Mayhew and Stivers 2003, Chakravarty et al 2004, Pan and Pote sh man 2006, Ni et al 2008, Taylor et al 2010, Pathak et al 2015 examine such inter-linkages across markets at firm level and provide mixed evidence of information content in prices and trading activity of the options market. However, our paper differs from existing studies on several grounds.…”

The option market’s anticipation of information content in earnings announcements

“…Should traders believe that they can forecast the direction of stock price changes associated with future earnings releases (see Amin and Lee, 1997), the current stock price will reflect these favorable/unfavorable beliefs. To the extent that option traders are uncertain about direction (i.e., they cannot assign an expected sign to the upcoming information), but anticipate an increase in stock price volatility around the earnings announcement, option prices should incorporate this expected variance (e.g., Ni et al, 2008; Xing et al, 2009).…”

“…Should traders believe that they can forecast the direction of stock price changes associated with future earnings releases (see Amin and Lee, 1997), the current stock price will reflect these favorable/unfavorable beliefs. To the extent that option traders are uncertain about direction (i.e., they cannot assign an expected sign to the upcoming information), but anticipate an increase in stock price volatility around the earnings announcement, option prices should incorporate this expected variance (e.g., Ni et al, 2008; Xing et al, 2009).Although we believe that option traders consider the ex post sensitivity of stock prices to earnings news and document that is indeed the case, we expect our volatility-driven information content metric to behave distinctly from the traditional earnings-return relation, as measured by …”

“…Recent empirical work indicates that option traders anticipate a stock-market reaction to firms' earnings disclosures (Amin and Lee, 1997;Ni et al, 2008;Xing et al, 2009). We use a powerful setting in the option market to develop an approach to studying information content that isolates the volatility-induced spike in option price that stems from traders' expectations of a stock market response to the release of earnings.…”