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Volatility Information Trading in Option Market

Posted: 25 Mar 2005  

Sophie X. Ni

Hong Kong University of Science and Technology

Jun Pan

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA); National Bureau of Economic Research (NBER); China Academy of Financial Research (CAFR)

Allen M. Poteshman

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: March 15, 2005

Abstract

Investors can trade on positive or negative information about firms in either the stock or the option market, and a well-developed literature examines the use of options to make directional trades. Surprisingly, very little is known about option market trading on volatility information, despite the fact that options are uniquely suited for such trading. This paper investigates volatility trading in the equity option market. Two principal predictions of the hypothesis that investors bring volatility information to the option market are that net non-market maker demand for volatility is positively related to the future volatility of underlying stocks and that market makers protect themselves from informed volatility traders by raising (lowering) option prices in response to increases (decreases) in net volatility demand. Using a dataset that allows us to construct net non-market maker demand for volatility at the Chicago Board Options Exchange over the 1990 through 2001 period, we find strong empirical support for both of these predictions. We also present two additional results which each provide further confirmation for the proposition that investors bring volatility information to the option market. First, non-market maker net volatility demand constructed from transactions which open new option positions is a stronger predictor of the future volatility of underlying stocks than net volatility demand constructed from transactions which close existing option positions. Second, the impact on option prices from each unit of net non-market maker volatility demand significantly increases as informational asymmetry intensifies in the days leading up to earnings announcement dates.

Suggested Citation

Ni, Sophie X. and Pan, Jun and Poteshman, Allen M., Volatility Information Trading in Option Market (March 15, 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=687261

Sophie Xiaoyan Ni (Contact Author)

Hong Kong University of Science and Technology ( email )

Clearwater Bay
Kowloon
Hong Kong
852-2358 5052 (Phone)

HOME PAGE: http://sophiexni.googlepages.com

Jun Pan

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA) ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States
617-253-3083 (Phone)
617-258-6855 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

Allen M. Poteshman

University of Illinois at Urbana-Champaign - Department of Finance ( email )

340 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
United States
217-265-0565 (Phone)
217-244-3102 (Fax)

HOME PAGE: http://www.business.uiuc.edu/poteshma

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