Option Volume and Stock Price Behavior: Some Evidence from the Chicago Board Options Exchange

By Boluch, Michael J.; Chamberlain, Trevor W. | Atlantic Economic Journal, December 1997 | Go to article overview

Option Volume and Stock Price Behavior: Some Evidence from the Chicago Board Options Exchange


Boluch, Michael J., Chamberlain, Trevor W., Atlantic Economic Journal


Introduction

Since stock options began trading on the Chicago Board Options Exchange (CBOE) in 1973, a number of studies have investigated whether information reaches and is acted upon by option and stock market participants simultaneously or whether one market's activity leads that of the other. Conventional wisdom seems to suggest that, if anything, option market activity leads stock market activity. Option trading typically involves lower transaction costs, less stringent restrictions on short selling, and greater liquidity than does stock trading [Chance, 1991]. For these reasons, informed investors may be attracted to the option market over the stock market, implying that the former will react first as new information arrives.

On the other hand, options derive their values from the underlying stocks. As such, option traders may not react based on how they expect the underlying stock to respond to new information but how, in fact, the stock does respond. If this is the case, the option market will follow the stock market.

A further possibility is that differences in transaction costs, short selling opportunities, and liquidity notwithstanding, information will reach the two markets simultaneously and be reflected in bid and ask prices, if not actual trades. If so, prices in one market will not lead those in the other and no systematic volume-price change relationship will exist.

Evidence on the subject is mixed but on balance suggests that trading activity and price adjustments in the option market lead those in the stock market. However, most of this evidence has been obtained using daily data. Lead-lag relationships may well involve much shorter periods. In the present paper, the options volume-stock price relationship for selected CBOE options is examined using intraday data. In order to measure volume, both the number of option transactions and the number of contracts traded are considered. However, before proceeding to the analysis, previous studies of stock option market relationships will be reviewed briefly.

Previous Studies

Most previous studies have investigated the data for relationships between prices in the two markets. Initially, the particular concern was whether closing option prices were leading indicators of closing stock prices. Using a response surface methodology, Panton [1976] concluded that call option prices could not be used to predict the underlying stock prices one and two months in advance. This result is not surprising in view of the long time period used. Manaster and Rendleman [1982], using daily closing option prices and stock prices implied by the Black-Scholes model, concluded that option prices lead and, therefore, reveal information not reflected in stock prices for periods of up to 24 hours. Chiras and Manaster [1978], also using the Black-Scholes model, found that closing option prices could be used to predict future stock prices and earn abnormal returns, even after allowing for transaction costs.

The studies based on closing prices were criticized by a number of authors, among them Bhattacharya [1987] and Stephan and Whaley [1990], who suggested that much of the apparent "lead" of the option market could be explained by differences in the timing of trades in the two markets. In their view, closing option prices on the CBOE, which is open for trading 10 minutes after the close of trading on the New York Stock Exchange (NYSE), capture information not reflected in closing stock prices. Bhattacharya [1987], using data supplied at 15-minute intervals, concluded that there was some information in option prices not present in contemporaneous stock prices but that it was insufficient to be used profitably. Stephan and Whaley [1990], in contrast, found that stock price changes led call option price changes by an average of 15 to 20 minutes.

There has also been a limited amount of work examining the relationship between the trading volumes in the stock and option markets. …

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