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

51 Pages Posted: 5 Jul 2016 Last revised: 25 Nov 2018

See all articles by Chang Mo Kang

Chang Mo Kang

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

Donghyun Kim

University of Wisconsin - Milwaukee

Geul Lee

NH Finance Research Institute

Date Written: November 15, 2018

Abstract

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.

Keywords: Options, return predictability, trading volume

JEL Classification: G11, G12, G13, G14

Suggested Citation

Kang, Chang Mo and Kim, Donghyun and Lee, Geul, Informed Trading of Out-of-the-Money Options and Market Efficiency (November 15, 2018). Available at SSRN: https://ssrn.com/abstract=2803724 or http://dx.doi.org/10.2139/ssrn.2803724

Chang Mo Kang

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Donghyun Kim (Contact Author)

University of Wisconsin - Milwaukee ( email )

Bolton Hall 802
3210 N. Maryland Ave.
Milwaukee, WI 53211
United States

Geul Lee

NH Finance Research Institute ( email )

16 Saemunan-ro
Jung-gu
Seoul, 04516
Korea, Republic of (South Korea)
+82-2-2080-6933 (Phone)
+82-2-2080-6895 (Fax)

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