Investor Behavior in the Option Market
Lakonishok, Lee and Poteshman
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.
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
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
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.
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.
Stated in points and fractions. One point equals $100. Minimum tick
for options trading below 3 is .05 and for all other series, .10.
Saturday immediately following the third Friday of the expiration
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
Option Market Activity Levels
N s ,t
100 OpenInterests , j ,t s , j ,t
k, i Call
OpenInterestPercentageSharessk,,t i j 1 100.
N s ,t
100 OptionVols , j ,t s , j ,t
k, i Call
OptionVolPercentageSharessk,,t i j 1 100.
S: underlying stock, t: trade date, k: kind of option, i: investor type i.
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
Full-Service Customers vs. Discount Customers
Full-service customers are likely to be more sophisticated than
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.
Average Daily Open Interest as a Percentage of Shares
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%
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
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?
K1 K2 ST
Buy Stock at K1 Sell Call with Strike Pr.= K2 > K1 Covered Call
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
Average Daily Open Volume as a Percentage of Shares Outstanding
Buy Call Volume > Sell Call Volume High turnover for short
Average Turnover Time in Trade Dates
To examine the factors related to option trading volume, we use a
Fama-McBeth type regression analysis.
Various option trading volume on each underlying stock on each
trade date for each investor class.
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
Volatility of underlying stocks = annualized sample standard
deviation of weekly log returns over the last 52 weeks excluding
two most extreme values
Large Stock Regression 1990-2001
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.
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
Large Stock Average Daily Open Volume as a Percentage of Shares Outstanding
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
Percentage Impact on Daily Open Buy Call Volume of One S.D.
Shock to Independent Variables
Value vs. Growth
Examine whether option trading behaviors are different for
underlying stocks with different characteristics.
Large Growth Stock Average Daily Open Volume as a Percentage of
Large Value Stock Average Daily Open Volume as a Percentage of
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.
Table 10: Open Buy Call Volume – During the Bubble
Percentage Impact on Daily Open Buy Call Volume of One S.D.
Shock to Independent Variables – During the Bubble
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
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.
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.
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
Relationship between arbitrage opportunities and option