Stock Return Predictability: Consider Your Open Options

44 Pages Posted: 20 Jul 2017 Last revised: 12 Sep 2017

See all articles by Farhang Farazmand

Farhang Farazmand

Citibank N.A.

Andre de Souza

St. John's University - Department of Economics and Finance; New York University (NYU) - Department of Finance

Date Written: September 9, 2017

Abstract

Investors' views, expressed in individual securities, when averaged are informative about the future path of aggregate market returns. Our predictor of the market, PC-OI, is an average of traders' positions in options on individual stocks, formed by simply dividing the total put open interest by the total call open interest. The totals sum across all stocks. Predictability is strongest when the measure is constructed from a subset of stocks subject to arbitrage constraints. PC-OI has strong in-sample and out-of-sample predictive power, and creates substantial utility gains to a mean-variance investor. The predictive power is not subsumed by the host of existing predictors in the literature. A trading strategy using our measure would have made up to 208% over our sample period, compared to a cumulative market return of 90%.

Keywords: Stock return predictability, options, open interest, limited attention, limits to arbitrage, idiosyncratic volatility.

JEL Classification: G11

Suggested Citation

Farazmand, Farhang and de Souza, Andre, Stock Return Predictability: Consider Your Open Options (September 9, 2017). Available at SSRN: https://ssrn.com/abstract=3003957 or http://dx.doi.org/10.2139/ssrn.3003957

Farhang Farazmand (Contact Author)

Citibank N.A. ( email )

2 Court Square
10th Floor
Long Island City, NY 1120
United States

Andre De Souza

St. John's University - Department of Economics and Finance ( email )

101 Astor Place, #244
New York, NY 10003
United States

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

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