The Gateway to Algorithmic and Automated Trading

Informed traders prefer options - academic research

First Published 18th March 2015

New research supports view that traders with informational advantages prefer to transact in option markets.

Andrew Fodor, Ohio University College of Business

Andrew Fodor, Ohio University College of Business

"Traders may respond to this research by better considering the correct instruments to use when attempting to take advantage of informational advantages."

Research from a group of academics suggests that skilled investors find profitable trading opportunities prior to and immediately following information being made public.

By correctly predicting the timing of events and their effect on stock values, they are able to make smart trading decisions around public announcements.

"Traders may respond to this research by better considering the correct instruments to use when attempting to take advantage of informational advantages," said Andrew Fodor, professor at Ohio University's College of Business and one of the authors of the published research.

"If the cost of betting is sufficiently high, losses may result from otherwise good trades," he added.

Researchers looked at a comprehensive archive provided by OptionMetrics of news releases, with a database of option volume initiated by either buyers or sellers to either open new positions or close existing positions.

They augmented open-buy trading volume data with option quote and implied volatility data from OptionMetrics, which provides end-of-day bid and ask quotes, open interest, volume, and implied volatility on all exchange-traded options.

"Experienced option traders have long suspected that informed traders prefer trading options to equities, and Cremers, Fodor, and Weinbaum have shown compelling empirical evidence of this phenomenon," said David Hait, founder of OptionMetrics. Data was made available via the firm's academic licensing programme.

Summary of findings

Researchers analysed the raw option-to-stock trading volume ratio, which indicated that option traders are more active than equity market participants around news events.

Given that option traders were more active before and immediately after the news events, they investigated whether news releases represent profitable opportunities. They found signed option trading volume contains information on future stock price changes around news releases.

And because earnings announcements are significant expected information events, implied volatility increases prior to earnings announcements and then drops off sharply immediately thereafter.

The researchers found this pattern reduces the profitability of trading strategies involving long option positions and increases profitability of strategies using short positions relative to when unexpected news events occur.

Specifically, Fodor, along with fellow researchers, Martijn Cremers, University of Notre Dame, and David Weinbaum of Syracuse University, found that if volatility remains constant around an event, then an informed investor with a positive signal is better off buying a call than selling a put, because of the greater leverage.

Similarly, an informed investor with a negative signal would benefit from buying a put than selling a call.

Conversely, they found that if the event is anticipated and implied volatility drops when the news is made public, then the opposite will be true: trading strategies that involve short option positions have greater leverage. Thus the researchers speculate that informed investors would not trade in options ahead of anticipated news announcements, except through short positions.

Read the entire research paper: 'Where Do Informed Traders Trade (First)? Option Trading Activity, News Releases, and Stock Return Predictability'