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Korea UniversityKorea University

Investor Behavior in the Option Market

ByBy Lakonishok, Lee and Poteshman Lakonishok, Lee and Poteshman

and and Presented byPresented byInmoo LeeInmoo Lee

Inmoo Lee

What do we do in this paper?What do we do in this paper?

Examine some basic facts about equity option markets using a comprehensive data of daily open interest and trading volume for Chicago Board Options Exchange listed options over the 1990 to 2001 period.

Examine different trading behavior of three different investor groups, firm-proprietary traders, full-service broker customers and discount broker customers.

Examine whether past returns affect trading behavior in equity options market. Are investors contrarian or trend chasers?

Examine whether trading behavior changes over the speculative bubble period in late 1990s and early 2000.

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Key FindingsKey Findings

Non-market maker investors have about four times more long call than long put open interestThese investors have more short than long open interest in both calls and putsEach type of investor purchases more calls to open new positions when the return on underlying stocks are higher over horizons ranging from one week to two years into the pastThe least sophisticated group of investors substantially increased their purchases of calls on growth but not value stocks during the stock market bubble of the late 1990s and early 2000None of the investor groups significantly increased their purchases of puts during the bubble period in order to overcome short sales constraints in the stock market

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CBOE DataCBOE Data

The CBOE provided this proprietary data.

The data cover option open interest and trading volume broken down by different types of investors.

The open interest data provide a daily record of closing short and long open interest for all CBOE listed options. The open interest data is inclusive of all exchanges at

which the option trades as far as it is traded at the CBOE.

The trading volume data consists of daily information of all trades that actually occurs at the CBOE. Open buy volume, open sell volume, close buy volume

and close sell volume.

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CBOE Equity Option Contract DetailsCBOE Equity Option Contract Details

Underlying:Generally, 100 shares of common stock or American Depository Receipts ("ADRs") of companies that are listed on securities exchanges or trade over-the-counter.Premium Quotation:Stated in points and fractions. One point equals $100. Minimum tick for options trading below 3 is .05 and for all other series, .10.Expiration Date:Saturday immediately following the third Friday of the expiration month.Exercise Style:American - Equity options generally may be exercised on any business day before the expiration date.Settlement of Option Exercise:Exercise notices properly tendered on any business day will result in delivery of the underlying stock on the third business day following exercise.

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Option Market Activity LevelsOption Market Activity Levels

Activity measures

S: underlying stock, t: trade date, k: kind of option, i: investor type i.

,,, , , ,

1,,

,

100

100.

Callss tN

k i Calls j t s j t

jk is t Shares

s t

OpenInterest

OpenInterestPercentageSharesN

,,, , , ,

1,,

,

100

100.

Callss tN

k i Calls j t s j t

jk is t Shares

s t

OptionVol

OptionVolPercentageSharesN

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Firm Proprietary InvestorsFirm Proprietary Investors

Investors trading for the bank’s own account.

Most sophisticated investors Poteshman and Servin (2003, JF) show that firm propri

etary traders never engage in irrational early exercise of stock options while the full-service and discount customers do so with some regularity.

Difficult to characterize since it is not uncommon for firm proprietary traders to place orders to facilitate the trades of their customers.

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Full-Service Customers vs. Discount CustomersFull-Service Customers vs. Discount Customers

Full-service customers are likely to be more sophisticated than discount customers. Most hedge funds trade through full-service brokerage houses Pan and Poteshman (2003, WP) find that full-service option trader

s have a greater propensity than discount option traders to open new long call (put) positions before stock price increases (decreases).

Mahani and Poteshman (2003, WP) shows that discount customers have a greater propensity for entering options positions that load up on growth stocks relative to value stocks in the days leading up to earnings announcements despite the fact that at earnings announcements value stocks outperform growth stocks by a wide margin (LaPorta, Lakonishok, Shleifer and Vishny, 1997, JF)

Barber, Odean and Zhu (2003, WP) show that the average value of accounts held by discount investors is less than half of the value of the full-service investors accounts.

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Table 1Table 1 Average Daily Open Interest as a Percentage of Shares Average Daily Open Interest as a Percentage of Shares

Outstanding, 1990-2001Outstanding, 1990-2001

Call OI > Put OI Full > Others For Full, Long

Call < Short Call Short Put >> Long

Put, especially for value stocks in Panels B and C

Underlying Stocks Long Call Long Put Short Call Short Put

All 0.041% 0.014% 0.030% 0.010%Large 0.042% 0.014% 0.031% 0.010%

Large Growth 0.044% 0.015% 0.032% 0.011%Large Value 0.039% 0.019% 0.041% 0.011%

All 0.032% 0.004% 0.025% 0.009%Large 0.031% 0.004% 0.023% 0.008%

Large Growth 0.039% 0.004% 0.027% 0.009%Large Value 0.032% 0.004% 0.024% 0.010%

All 0.130% 0.031% 0.195% 0.048%Large 0.126% 0.029% 0.191% 0.046%

Large Growth 0.134% 0.032% 0.211% 0.047%Large Value 0.159% 0.036% 0.190% 0.068%

Panel B: Discount Customers

Panel C: Full-Service Customers

Type of Open Interest

Panel A: Firm Proprietary Traders

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Long Call vs. Long PutLong Call vs. Long Put

It is easy to take long bets but difficult to take short positions, implying that long put might be traded more than long calls

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Long Call vs. Short CallLong Call vs. Short Call

Covered calls are heavily promoted by brokers as a conservative way to take a long position. Part of the cost of buying the stock is offset by the premium received from the sales of call options.

Prospect theory agents should prefer covered call positions to buying the stock alone. Why?

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Covered CallCovered Call

K1K2

-K1

Call

-K1+Call

STK1K2

Profit/Loss Profit/LossProfit/Loss

Buy Stock at K1 Sell Call with Strike Pr.= K2 > K1 Covered Call

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Prospect TheoryProspect Theory

Value

Losses Gaines

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Long Put vs. Short Put for Value StocksLong Put vs. Short Put for Value Stocks

If investors believe that shares are currently undervalued, it will be optimal to sell out-of-the-money put options. If price goes down further, option will be exercised

ending up with buying stocks at a price which is even lower than the current price. In addition, you will keep the put premium.

If you price goes up as expected, then you will take the premiums.

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Table 2Table 2Average Daily Open Volume as a Percentage of Shares OutstandingAverage Daily Open Volume as a Percentage of Shares Outstanding

Buy Call Volume > Sell Call Volume High turnover for short position?

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Table 2Table 2Average Turnover Time in Trade DatesAverage Turnover Time in Trade Dates

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Regression AnalysisRegression Analysis

To examine the factors related to option trading volume, we use a Fama-McBeth type regression analysis.Dependent variables Various option trading volume on each underlying stock on each tr

ade date for each investor class.Independent variables Rsameday = the same day return Rweek = the return from trade dates -1 through -5 Rmonth = the return from trade dates -6 through -21 Rquarter = the return from trade dates -22 through -63 Ryear = the return from trade dates -64 through -252 R2year = the return from trade dates -253 through -504 Ln(BM) Volatility of underlying stocks = annualized sample standard devia

tion of weekly log returns over the last 52 weeks excluding two most extreme values

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Table 3Table 3Large Stock Regression 1990-2001Large Stock Regression 1990-2001

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Table 3Table 3

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Trading Volume vs. Past Stock ReturnsTrading Volume vs. Past Stock Returns

Open buy call volume results suggest that discount and full-service customers appear to be trend-chasers.

The significant positive coefficients for all return variables for open sell call volume, especially for full-service customers, are consistent with the large covered call position held by full-service customers.

Open buy put volume tend to increase as the stock price increases.

Open short put volume decreases (increases) as the recent (more distant past) stock price increases. This is consistent with investors believing that weakness in an underlying stock in the past quarter is temporary.

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Option Market Activity During the BubbleOption Market Activity During the Bubble

Use regression analysis for subperiods to examine whether option trading behavior has changed over time.

S&P 500 Index

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600

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1000

1200

1400

1600

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199001

199101

199201

199301

199401

199501

199601

199701

199801

199901

200001

200101

Pre-bubble Beg-bubble Height-bubble Post-bubble

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Figure 2Figure 2

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Table 5Table 5Large Stock Average Daily Open Volume as a Percentage of Shares OutstandingLarge Stock Average Daily Open Volume as a Percentage of Shares Outstanding

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Option Market Activity Through TimeOption Market Activity Through Time

The least sophisticated discount investors in the market substantially increased their option market speculation that stock prices would rise throughout the bubble and then dramatically cut their option market bets that stock prices would increase after the bubble burst.By contrast, the full-service customer open buy call volume is more stable. Moreover, the bubble appears to be essentially a non-event for the firm proprietary traders.There is no major increase in open buy put volume, especially for full-service customers, during the bubble period. This casts doubt on the role of short sales constraints in

explaining the bubble (e.g., Ofek and Richardson (2003, JF)).

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Table 7Table 7Percentage Impact on Daily Open Buy Call Volume of One S.D. Percentage Impact on Daily Open Buy Call Volume of One S.D.

Shock to Independent VariablesShock to Independent Variables

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Value vs. GrowthValue vs. Growth

Examine whether option trading behaviors are different for underlying stocks with different characteristics.

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Table 9Table 9Large Growth Stock Average Daily Open Volume as a Percentage of Large Growth Stock Average Daily Open Volume as a Percentage of

Shares OutstandingShares Outstanding

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Table 9Table 9Large Value Stock Average Daily Open Volume as a Percentage of Large Value Stock Average Daily Open Volume as a Percentage of

Shares OutstandingShares Outstanding

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Value vs. GrowthValue vs. Growth

Discount customers became more trend chasing for growth stocks during the bubble but did not increase their activity in value stocks during the bubble.

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Table 10: Open Buy Call Volume – During the BubbleTable 10: Open Buy Call Volume – During the Bubble

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Table 11Table 11Percentage Impact on Daily Open Buy Call Volume of One S.D. Percentage Impact on Daily Open Buy Call Volume of One S.D.

Shock to Independent Variables – During the BubbleShock to Independent Variables – During the Bubble

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ConclusionConclusion

Show that equity option market activity is a reasonably large fraction of activity in the underlying assetsInvestors buy substantially more call options than put optionsInvestors have more short call open interest than long call open interest Prevalence of covered call positions

Strong positive relationship between the past returns on the underlying stock and the trading volume of call options. It appears that all three classes of investors were trend

chasing past returns at various horizons.

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ConclusionConclusion

The discount customer’s long call open interest substantially increased during the bull market, while that of other types of investors did not show such a dramatic change. The least sophisticated segment of the market took

positions based on optimistic sentiment during the height of the bubble.

For the growth stocks, the discount customers increased their long call open volume during the bubble period while other types of investors did not. For value stocks, there were no dramatic changes for all three types of investors.

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Future StudiesFuture Studies

Examination of equity option trading behavior around various corporate event dates and macro economic event dates. Is the equity option market used as a way to avoid short

sales constraints?

Relationship between arbitrage opportunities and option trading volume.