August 27, 2003
Option traders must watch stock market momentum
ANN ARBOR, Mich.—New research by a University of Michigan Business School professor reveals that recent stock-market momentum, upward or downward, drives increases in the cost of option prices, thereby making it more expensive for traders to buy calls or puts.
These findings underscore the fact that pricing options in the real world is more complicated than economists' standard option-pricing formulas indicate, according to H. Nejat Seyhun, professor of finance at the University of Michigan Business School.
"Our results suggest that recent stock returns exert an important influence on index option prices," Seyhun said. "This creates opportunity as well as potential problems for investors who trade options."
In a study forthcoming in the Journal of Business, Seyhun and colleagues Kaushik Amin of Lehman Brothers and Joshua Coval of Harvard University examined the Standard & Poor's 100 index option prices from 1983 to 1995.
They discovered that after recent stock market advances, the demand for call options increased, creating an upward pressure on call prices (a call is an investor's right to purchase a prescribed number of shares of a stock at a specific price on or before a specified date).
Similarly, after recent stock market declines, the demand for puts strengthened, boosting the option prices for puts (a "put" is an option to sell a stock at a predetermined price within a specific time period).
The researchers also found that additional factors, which are explicitly excluded in theoretical models, enter into option pricing. These include investors' expectations about future stock returns, their degree of risk aversion and their skewness preference (the occurrence of an unlikely event, such as a corporate takeover, company bankruptcy or market crash, that potentially could skew the returns in an extreme direction).
"The bottom line is that investors must plan ahead if they trade options," Seyhun said. "Since recent positive market returns increase the price of call options and negative market returns increase the price of put options, traders can't wait to buy calls or puts until everyone else gets the same idea. By then, the option price will be disadvantageously higher."
Following large stock-market increases, Seyhun suggests, traders may be better off using the futures contracts or underlying stocks, instead of options, to place bets on further stock-market advances. Similarly, for investors interested in buying puts for portfolio insurance, the price of the insurance increases after declines in the stock market.
For those seeking to buy put options, those options are cheaper after rises in the stock market. Similarly, calls are cheaper after stock-market falls.
For more information about Seyhun, visit http://www.bus.umich.edu/FacultyBios/FacultyBio.asp?id=000315574.
Contact: Bernie DeGroat