Trading in equity options is attractive to individual investors because of its considerable embedded leverage and the opportunity it presents for lottery-like wins.
The attraction exists despite the fact that there is now a large body of research (see here, here, here and here) showing that options trading, particularly the buying of calls, has resulted in the transfer of billions of dollars from the wallets of retail investors to the pockets of the market makers of those options. That explains all the commercials from broker-dealers touting their options trading offerings!
The empirical findings demonstrated that the poor results are mainly the consequence of retail investors basing trading decisions on sentiment rather than fundamentals. Investor sentiment—the propensity of individuals to trade on noise and emotions rather than facts—represents investors’ beliefs about future cash flows that the prevailing fundamentals cannot explain.
Research—including the 2006 study “Investor Sentiment and the Cross-Section of Stock Returns,” the 2012 studies “Global, Local, and Contagious Investor Sentiment” and “The Short of It: Investor Sentiment and Anomalies,” and the 2018 study “Investor Sentiment: Predicting the Overvalued Stock Market”—has found that such activity can lead to mispricing, especially for hard-to-arbitrage stocks and during periods of high investor interest. Eventually, any mispricing would be expected to be corrected when the fundamentals are revealed, making investor sentiment a contrarian predictor of stock market returns.
An interesting question is: Does retail option trading predict equity returns? To answer that, Jie Cao, Gang Li, Xintong Zhan and Guofu Zhou, authors of the December 2022 study “Betting Against the Crowd: Option Trading and Market Risk Premium,” examined how equity option trading affects the market risk premium. They constructed a variable to capture call buying pressure, the “equity call option order imbalance” (CIB)—defined as the net open buying option volume divided by the total open trading option volume for each individual stock at a certain point of time. They aggregated “all available CIBs to the market level by taking the market-value weighted average in cross-section,” which they called aggregate equity called option order imbalance (ACIB). A positive CIB (put) order imbalance (PIB) indicated that there was more buying pressure than selling pressure from call (put) option end users. Their database consisted of all available trading volume data in the Chicago Board Options Exchange (CBOE) database from 2005 to 2020. Their key findings show:
- ACIB negatively forecasted future stock market returns significantly from days to months. For example, a one-standard-deviation increase in ACIB forecasted a statistically significant average decrease in stock market returns of 0.070% next day, 0.232% next week, 1.024% next month and 1.974% next quarter (corresponding t-statistics of ‑2.94, ‑2.43, -2.91 and -2.94).
- The Sharpe ratios of using ACIB as the trading signal to construct market-timing portfolios were 0.205 for three days, 0.395 for one week and 1.058 for one month—all higher than those of the buy-and-hold benchmark of 0.174 for three days, 0.252 for one week and 0.725 for one month.
- ACIB represented an option-based investor sentiment measure that accounted for excess option buying or selling and was highly correlated with the stock investor sentiment.
- They did not find such predictive power from using a similar aggregate equity put option order imbalance (APIB). One explanation is that the sentiment effect can be stronger for lottery-like call options than protection-like put options, especially for unsophisticated option traders and speculators. Another is that unlike optimistic investors, pessimistic traders can simply do nothing and leave the market when they lose confidence; thus, their views are not reflected in put option trading activities.
- The predictive power of ACIB was more prominent among options driven by retail (naive, sentiment-driven) investors.
- ACIB was highly correlated with investor sentiment indices—ACIB had a correlation of 0.50 with the Baker and Wurgler investor sentiment index, a correlation of 0.36 with the University of Michigan consumer sentiment index, and a correlation of 0.36 with the option price-based sentiment index proposed by Gao and Martin in their 2021 study, “Volatility, Valuation Ratios, and Bubbles: An Empirical Measure of Market Sentiment.”
- The predictive power of ACIB was significant only in those regimes in which sentiment played a greater role.
- Constructing ACIB (APIB) using either professional customers’ order flows or order flows from market makers, there was no evidence of any predictive power of ACIB (APIB).
Their findings led Cao, Li, Zhan and Zhou to conclude: “The predictive power of ACIB forecasting market risk premium comes from general sentiment trading behavior among equity option traders, especially the retail investors who are overly optimistic or pessimistic.” They explained: “When investors are overly-optimistic about future stock market performance, accompanied with greater gambling activities in the equity option market, aggregate stocks are likely to be overpriced because of the overbought demand of equity option, leading to lower stock market returns in the future.” They added: “Our evidence is consistent with the view that retail investors are sensitive to the underlying stocks’ current performance, thus leading to overbought (too bullish) or oversold (too bearish) reactions of option trading.” They also noted: “The asymmetric effect of the predictive power between ACIB and APIB reflects different motivations to trade equity call and put options. While equity call option trading in general is driven by sentiment, equity put option trading is mainly driven by hedging demand.” And finally: “All in all, we show that investors can significantly benefit from using our variable ACIB to adjust positions of risky assets over time.”
Investor takeaways
Investment decisions should be based on empirical research findings, not opinions, and as the evidence clearly demonstrates, not on investor sentiment. Thus, the takeaway for investors is to avoid being a noise trader. Don’t get caught up in following the herd over the investment cliff. Stop paying attention to prognostications in the financial and social media. Have a well-developed, written investment plan and develop the discipline to stick to it, rebalancing when needed and harvesting losses as opportunities present themselves.
One of the most important roles of a good investment advisor is preventing clients from engaging in wealth-destructive behaviors. Providing clients with the evidence on option trading increases the odds that they can be convinced against engaging in such activities.
Larry Swedroe has authored or co-authored 18 books on investing. His latest is “Your Essential Guide to Sustainable Investing.” All opinions expressed are solely his opinions and do not reflect the opinions of Buckingham Strategic Wealth or its affiliates. This information is provided for general information purposes only and should not be construed as financial, tax or legal advice. LSR-22-429
