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

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