SINGAPORE (Oct 14): The concept and use of financial options have existed for centuries. One of the earliest documented option trades is found in Aristotle’s fourth-century BC book, Politics, in which he documents how Thales of Miletus profited from a plentiful olive harvest by using an options contract.
Anatomy of an option
Simply put, an option is like a prepaid dis-counted voucher that gives the right to buy or sell the underlying asset at a fixed price, with a maturity date. This allows investors to make a profit if the price moves in their favour.
According to Aristotle, Thales predicted that his region would receive a bountiful olive harvest, which would mean a high demand for olive presses. Despite not owning olive presses, Thales set out to corner the market by paying olive press owners for the first right to use their presses (a call option) at harvest time (by paying the option premium). The harvest was indeed plentiful, and farmers had a hard time accessing olive presses because of Thales’ arrangement. He then exercised his option and sold his right to use the olive presses to those who needed them, making a tidy profit.
Price analysis can provide valuable clues
Back to the present, options are a widely accepted derivative contract with a mixed reputation. Lack of understanding and errant trades have led to options’ being perceived as a high-risk investment instrument.
In a study at the National University of Singapore (NUS) Business School, we analysed the difference between the option-implied and traded prices of a stock. Option-implied prices refer to share prices derived from observed option prices, under assumptions that prevent arbitrage. We found that oftentimes, there is a difference between option-implied prices and share prices, and this difference unveils valuable information about the stock value.
My fellow researchers and I studied a 17-year sample of prices and returns of stocks traded on the New York Stock Exchange, Nasdaq and American Stock Exchange and those derived from options data sourced from OptionMetrics, a provider of option pricing information.
Four key findings emerged: Understand why option-implied and traded share prices differ
Often, there is a difference between the option-implied and traded share prices, or DOTS for short. Both are affected by the company’s fundamentals such as reported financials, business strategy, market conditions and expectations about future performance. They reflect investors’ view of a company’s value.
Share prices may also be influenced by extreme buy or sell trades, creating pressures that drive share prices temporarily away from fundamental values. But such trading demand shock does not necessarily propagate to the options market. Unlike stock trading, where there is a finite number of shares available, traders can easily create options contracts, thus implying a relatively higher elasticity of supply of options compared with stocks. Thus, trading-induced stock-price pressure generates high DOTS.
Another reason for high DOTS is that the options market attracts more informed traders because of the leverage implicit in options. Consequently, the option-implied prices incorporate information faster than the stock market.
In either case, when the option-implied price is higher than the traded share price, or positive DOTS, share prices tend to trade upwards and align with the option-implied price. Conversely, when the option-implied price is less than the share price, or negative DOTS, share prices are expected to decrease to align with the option-implied price. By understanding what caused the difference between the option-implied price and share price, investors can have greater clarity on the source and direction of the traded share price.
Predictable stock returns disappear as fast as they appear
When large DOTS is observed, it predicts the direction of the share price movements. Specifically, stocks with large positive DOTS outperform stocks with large negative DOTS by about 80 basis points over the next day. Consistent with the notion that DOTS are related to temporary stock price pressure, the share price converges to the option-implied price within one or two days.
Price pressure higher in small, illiquid stocks
Extreme DOTS readings are more commonly observed for small companies whose shares are thinly traded. The illiquid nature of these stocks is also reflected in the bidask spread, which is the difference between what buyers are willing to pay and what sellers are willing to receive. Hence, strong gains in trading stocks in extreme DOTS are accompanied by illiquidity, which makes trading costly for small investors.
What does this mean for investors?
When stocks have extreme returns, it could be due to new information or price pressure from heavy stock trading. For example, a large negative stock return could be due to bad corporate news or heavy selling for non-informational reasons such as when a large investor sells the stock to meet heavy withdrawals from their investment fund.
If the large price decline is due to bad news, prices will not revert, as they reflect the new information. If the decline is due to selling pressure, we expect DOTS to increase significantly, and prices to reverse subsequently when the pressure subsides.
Hence, by anchoring stock prices implied by the options market, DOTS provides an important measure to identify temporary price pressure that some investors can profit from. It also helps investors distinguish between fundamental changes in stock value from price changes due to market frictions. Today, trading equities is convenient and machines are programmed to optimise trading. However, the basic caveats remain relevant regardless of investment vehicle: Investors should have a clear knowledge of how it works, understand the underlying assets and assess the best approach for their investment strategy.
Allaudeen Hameed is Tang Peng Yeu Professor in Finance at the National University of Singapore Business School. The opinions expressed are those of the writer and do not represent the views and opinions of NUS.
