Exploiting Option Information in the Equity Market

Posted Apr 12 2012 by Wesley R. Gray, Ph.D. in 

Exploiting Option Information in the Equity Market

Guido Baltussen, Bart Van Der Grient, Wilma De Groot, Erik Hennink and Weili Zhou

Key Points:

  • Long/Short Value-Weighted alpha estimates of 118bp monthly. Sample covers data from 1996 to 2009.
  • Values come from information diffusions between stocks and options.

Abstract

Public option market information contains exploitable information for equity investors for an investable universe of liquid large-cap stocks. Strategies based on several option measures predict returns and alphas on the underlying stock. Transaction costs are an important factor given the high turnover of these strategies, but significant net alphas can be obtained when using a simple transaction cost reducing approach. These findings suggest that information diffuses from the option market into the underlying stock market.

Strategy Summary

  1. Calculate OTM skew, ATM skew, Changes in ATM skew and Spreads of realized and implied volatility.
  2. Calculate z-scores for each variables. (Z-score of a variable is constructed by subtracting its cross-sectional median from the values of the variable and dividing by its median absolute deviation)
  3. Sort 1,250 largest stocks into quintile portfolios base on average z-scores.
  4. Construct a value-weighted portfolio by longing stocks in the first quintile and shorting stocks in the last quintile.
  5. Do a weekly rebalance and make money.

To juice up:

  1. Calculate Z-scores for each variable then sort stocks base on average Z-scores.
  2. Use decile portfolios instead of quintiles and earn monthly alpha of 1.1%;
  3. Use value-weighted portfolios and quintiles to earn monthly alpha of 1.18%.

Comments and Investment Implications

  • Significant alphas exist after controlling various  factors such as value, momentum, size and market; and in out-of-sample tests during bear, bull, volatile, and calm markets.
  • Alphas can be significantly reduced when appling 7bp transaction cost in a sample of largest 1,250 US stocks. However, an annualized 7% net return could be achieved.

The full report is over at http://empiritrage.com/2012/04/12/applied-academic-research-april-2012/

Categories: 

About the Author

Wesley R. Gray, Ph.D.Better known as "The Turnkey Analyst, Ph.D.", Executive Managing Member, Empiritrage, LLC, Assistant Professor of Finance, Drexel University’s LeBow College of Business, United States Marine Corps, Captain, Ground Intelligence Officer, Published author; featured speaker, author, and lecturer at numerous venues (top-tier universities, museums, radio, and television), Ph.D./M.B.A. Finance, University of Chicago Booth School of Business, B.S. The Wharton School, University of Pennsylvania, magna cum laude Wes' homepage is at http://welcometotheadventure.com/View all posts by Wesley R. Gray, Ph.D. →

Disclaimer: TurnkeyAnalyst.com is not an investment adviser, brokerage firm, or investment company. The use of any information on this site does not guarantee performance. Past results are not necessarily indicative of future performance. Empiritrage, LLC and TurnkeyAnalyst.com are both owned in part by Wesley R. Gray, Ph.D.