Equity Option Market Activity 1

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					           Korea University

Investor Behavior in the Option Market

        Lakonishok, Lee and Poteshman

                Presented by
                 Inmoo Lee

          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.

                          Inmoo Lee
                    Key Findings
Non-market maker investors have about four times more
long call than long put open interest
These investors have more short than long open interest in
both calls and puts
Each 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
The 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 2000
None 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
                          Inmoo Lee
                    CBOE 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
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.

                           Inmoo Lee
    CBOE Equity Option Contract Details
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
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

                              Inmoo Lee
                    Option Market Activity Levels

       Activity measures

                                          N s ,t                                    

                                           100  OpenInterests , j ,t   s , j ,t 
                                                               k, i        Call

OpenInterestPercentageSharessk,,t i      j 1                                        100.
                                                    N sShares                       
                                                                                    
                                                                                    
                                                                                    
                                           N s ,t                                 

                                            100  OptionVols , j ,t   s , j ,t 
                                                               k, i       Call

  OptionVolPercentageSharessk,,t i        j 1                                     100.
                                                    N sShares                     
                                                                                  
                                                                                  
                                                                                  

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

                                           Inmoo Lee
            Firm Proprietary Investors

Investors trading for the bank’s own account.
Most sophisticated investors
  Poteshman and Servin (2003, JF) show that firm
   proprietary 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.

                            Inmoo Lee
Full-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 traders
    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.

                                Inmoo Lee
                                     Table 1
      Average Daily Open Interest as a Percentage of Shares
                    Outstanding, 1990-2001

                               Type of Open Interest
Underlying Stocks Long Call Long Put Short Call Short Put     Call OI > Put OI
              Panel A: Firm Proprietary Traders               Full > Others
       All           0.041%     0.014%     0.030%    0.010%
     Large           0.042%     0.014%     0.031%    0.010%   For Full, Long
 Large Growth        0.044%     0.015%     0.032%    0.011%   Call < Short Call
  Large Value        0.039%     0.019%     0.041%    0.011%   Short Put >> Long
                Panel B: Discount Customers                   Put, especially for
       All           0.032%     0.004%     0.025%    0.009%
                                                              value stocks in
     Large           0.031%     0.004%     0.023%    0.008%
 Large Growth        0.039%     0.004%     0.027%    0.009%   Panels B and C
  Large Value        0.032%     0.004%     0.024%    0.010%
               Panel C: Full-Service Customers
       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%

                                       Inmoo Lee
               Long 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

                           Inmoo Lee
             Long 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?

                          Inmoo Lee
                                    Covered Call

 Profit/Loss                                            Profit/Loss


                                                                      K1   K2         ST
           K1                             K2

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

                                          Inmoo Lee
          Prospect Theory


Losses                       Gaines

                 Inmoo Lee
    Long 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

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

 Buy Call Volume > Sell Call Volume       High turnover for short

                              Inmoo Lee
             Table 2
Average Turnover Time in Trade Dates

               Inmoo Lee
                    Regression 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
    trade 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
    deviation of weekly log returns over the last 52 weeks excluding
    two most extreme values

                                 Inmoo Lee
           Table 3
Large Stock Regression 1990-2001

             Inmoo Lee
Table 3

  Inmoo Lee
    Trading 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
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.

                           Inmoo Lee
                    Option Market Activity During the Bubble
                Use regression analysis for subperiods to examine whether
                option trading behavior has changed over time.
                                                      S&P 500 Index


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









































                                                             Inmoo Lee
Figure 2

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

                                    Inmoo Lee
    Option 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
  This casts doubt on the role of short sales constraints in
   explaining the bubble (e.g., Ofek and Richardson
   (2003, JF)).

                           Inmoo Lee
                        Table 7
Percentage Impact on Daily Open Buy Call Volume of One S.D.
              Shock to Independent Variables

                           Inmoo Lee
                 Value vs. Growth

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

                          Inmoo Lee
                          Table 9
Large Growth Stock Average Daily Open Volume as a Percentage of
                     Shares Outstanding

                             Inmoo Lee
                          Table 9
Large Value Stock Average Daily Open Volume as a Percentage of
                     Shares Outstanding

                            Inmoo Lee
                  Value 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.

                           Inmoo Lee
Table 10: Open Buy Call Volume – During the Bubble

                       Inmoo Lee
                       Table 11
Percentage Impact on Daily Open Buy Call Volume of One S.D.
     Shock to Independent Variables – During the Bubble

                           Inmoo Lee

Show that equity option market activity is a reasonably
large fraction of activity in the underlying assets
Investors buy substantially more call options than put
Investors 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.

                          Inmoo Lee

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
  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.

                           Inmoo Lee
                   Future Studies

Examination of equity option trading behavior around
various corporate event dates and macro economic event
  Is the equity option market used as a way to avoid short
    sales constraints?
Relationship between arbitrage opportunities and option
trading volume.

                          Inmoo Lee

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