Exploiting Option Information in the Equity Market

April 12, 2012 Academic Research Recap, Architect Academic Insights
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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/




About the Author

Wesley R. Gray, Ph.D.

Dr. Gray has been an active participant in financial markets for over 15 years. His experience includes positions as a Captain in the United States Marine Corps, as a finance professor at Drexel University, and as a portfolio manager for a special-situations hedge fund. Education and entrepreneurship has been the focus of his professional endeavors and his research interests are focused on the performance of portfolio managers and behavioral finance. Dr. Gray is currently the Executive Managing Member of Alpha Architect, an SEC-Registered Investment Advisor. Dr. Gray has published two books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army and QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. His work has been highlighted on CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


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  • http://www.scottsinvestments.com scottsinvestments

    Any plans on tracking this strategy and its holdings with the new site?

  • http://welcometotheadventure.com/ Wesley R. Gray, Ph.D.

    Really difficult to get the redistribution contracts with the necessary data to make something like that happen. We keep internal models to do this sort of thing, but our data agreements won’t allow us to display publicly :(