Option Informed Stock Picking

Abstract

A wide range of research has suggested that informed trading in options markets may effectively signal subsequent changes in equity prices. In this article, the authors analyze the performance of long/short strategies based on a number of signals from options markets. In addition, they create an easily implemented long-only strategy based on a subset of the signals (volatility risk premium, option/stock volume ratio, implied volatility skew, and realized volatility). In order to minimize transaction costs and liquidity issues, they restrict their analysis to S&P 500 constituents, rebalance the portfolio monthly, and limit the holdings to 50 individual stocks. The analysis of the period from 1996 through mid-2015 shows significant outperformance of a long-only, equal-weighted portfolio of 50 stocks (and found similar results when considering 10-stock portfolios), relative to the S&P 500 and the equal-weighted S&P 500. A return attribution analysis confirms that the outperformance is provided by individual stock selection rather than sector selection.