How Informationally Efficient Are Options Markets?

Abstract

The ability of option-based measures to predict future stock returns is not a sufficient condition for the existence of incremental information in options. If options markets are informationally more efficient than the stock market, then option measures may be used to predict future actual stock returns, but there should be weaker or no predictability for future synthetic (option-implied) stock returns. We propose to extract the incremental information in option-based measures from their ability to predict the spread between actual and synthetic stock returns. We document that existing proxies for informed option trading, such as the option-to-stock volume ratio, are unable to predict this spread around the release of scheduled and unscheduled firm-specific news. This is evidence inconsistent with the greater informational efficiency of the options markets, and casts doubt on the existence of incremental information in options. The empirical analysis is motivated using a noisy rational expectations model with informed investors who can trade simultaneously in stock and options.

Keywords: Information Markets, Put-Call Parity, Synthetic Returns, Predictability

JEL Classification: G11, G12, C13