Investor Behavior in the Option Market By Lakonishok, Lee and Poteshman and Presented by Inmoo Lee

1. Investor Behavior in the Option Market By Lakonishok, Lee and Poteshmanand Presented byInmoo Lee

2. What do we do in this paper? • Examine some basic facts about equity option markets using a comprehensive data of daily open interest and trading volume for Chicago Board Options Exchange listed options over the 1990 to 2001 period. • Examine different trading behavior of three different investor groups, firm-proprietary traders, full-service broker customers and discount broker customers. • Examine whether past returns affect trading behavior in equity options market. • Are investors contrarian or trend chasers? • Examine whether trading behavior changes over the speculative bubble period in late 1990s and early 2000.

3. Key Findings • Non-market maker investors have about four times more long call than long put open interest • These investors have more short than long open interest in both calls and puts • Each type of investor purchases more calls to open new positions when the return on underlying stocks are higher over horizons ranging from one week to two years into the past • The least sophisticated group of investors substantially increased their purchases of calls on growth but not value stocks during the stock market bubble of the late 1990s and early 2000 • None of the investor groups significantly increased their purchases of puts during the bubble period in order to overcome short sales constraints in the stock market

4. CBOE Data • The CBOE provided this proprietary data. • The data cover option open interest and trading volume broken down by different types of investors. • The open interest data provide a daily record of closing short and long open interest for all CBOE listed options. • The open interest data is inclusive of all exchanges at which the option trades as far as it is traded at the CBOE. • The trading volume data consists of daily information of all trades that actually occurs at the CBOE. • Open buy volume, open sell volume, close buy volume and close sell volume.

5. CBOE Equity Option Contract Details • Underlying:Generally, 100 shares of common stock or American Depository Receipts ("ADRs") of companies that are listed on securities exchanges or trade over-the-counter. • Premium Quotation:Stated in points and fractions. One point equals $100. Minimum tick for options trading below 3 is .05 and for all other series, .10. • Expiration Date:Saturday immediately following the third Friday of the expiration month. • Exercise Style:American - Equity options generally may be exercised on any business day before the expiration date. • Settlement of Option Exercise:Exercise notices properly tendered on any business day will result in delivery of the underlying stock on the third business day following exercise.

6. Option Market Activity Levels • Activity measures S: underlying stock, t: trade date, k: kind of option, i: investor type i.

7. Firm Proprietary Investors • Investors trading for the bank’s own account. • Most sophisticated investors • Poteshman and Servin (2003, JF) show that firm proprietary traders never engage in irrational early exercise of stock options while the full-service and discount customers do so with some regularity. • Difficult to characterize since it is not uncommon for firm proprietary traders to place orders to facilitate the trades of their customers.

8. Full-Service Customers vs. Discount Customers • Full-service customers are likely to be more sophisticated than discount customers. • Most hedge funds trade through full-service brokerage houses • Pan and Poteshman (2003, WP) find that full-service option traders have a greater propensity than discount option traders to open new long call (put) positions before stock price increases (decreases). • Mahani and Poteshman (2003, WP) shows that discount customers have a greater propensity for entering options positions that load up on growth stocks relative to value stocks in the days leading up to earnings announcements despite the fact that at earnings announcements value stocks outperform growth stocks by a wide margin (LaPorta, Lakonishok, Shleifer and Vishny, 1997, JF) • Barber, Odean and Zhu (2003, WP) show that the average value of accounts held by discount investors is less than half of the value of the full-service investors accounts.

9. Table 1Average Daily Open Interest as a Percentage of Shares Outstanding, 1990-2001 • Call OI > Put OI • Full > Others • For Full, Long Call < Short Call • Short Put >> Long Put, especially for value stocks in Panels B and C

10. Long Call vs. Long Put • It is easy to take long bets but difficult to take short positions, implying that long put might be traded more than long calls

11. Long Call vs. Short Call • Covered calls are heavily promoted by brokers as a conservative way to take a long position. Part of the cost of buying the stock is offset by the premium received from the sales of call options. • Prospect theory agents should prefer covered call positions to buying the stock alone. Why?

12. Covered Call Profit/Loss Profit/Loss Profit/Loss Call K2 ST K1 K2 K1 -K1+Call -K1 Buy Stock at K1 Sell Call with Strike Pr.= K2 > K1 Covered Call

13. Prospect Theory Value Losses Gaines

14. Long Put vs. Short Put for Value Stocks • If investors believe that shares are currently undervalued, it will be optimal to sell out-of-the-money put options. • If price goes down further, option will be exercised ending up with buying stocks at a price which is even lower than the current price. In addition, you will keep the put premium. • If you price goes up as expected, then you will take the premiums.

15. Table 2Average Daily Open Volume as a Percentage of Shares Outstanding Buy Call Volume > Sell Call Volume High turnover for short position?

16. Table 2Average Turnover Time in Trade Dates

17. Regression Analysis • To examine the factors related to option trading volume, we use a Fama-McBeth type regression analysis. • Dependent variables • Various option trading volume on each underlying stock on each trade date for each investor class. • Independent variables • Rsameday = the same day return • Rweek = the return from trade dates -1 through -5 • Rmonth = the return from trade dates -6 through -21 • Rquarter = the return from trade dates -22 through -63 • Ryear = the return from trade dates -64 through -252 • R2year = the return from trade dates -253 through -504 • Ln(BM) • Volatility of underlying stocks = annualized sample standard deviation of weekly log returns over the last 52 weeks excluding two most extreme values

18. Table 3Large Stock Regression 1990-2001

19. Table 3

20. Trading Volume vs. Past Stock Returns • Open buy call volume results suggest that discount and full-service customers appear to be trend-chasers. • The significant positive coefficients for all return variables for open sell call volume, especially for full-service customers, are consistent with the large covered call position held by full-service customers. • Open buy put volume tend to increase as the stock price increases. • Open short put volume decreases (increases) as the recent (more distant past) stock price increases. This is consistent with investors believing that weakness in an underlying stock in the past quarter is temporary.

21. Option Market Activity During the Bubble • Use regression analysis for subperiods to examine whether option trading behavior has changed over time. Pre-bubble Beg-bubble Height-bubble Post-bubble

22. Figure 2

23. Table 5Large Stock Average Daily Open Volume as a Percentage of Shares Outstanding

24. Option Market Activity Through Time • The least sophisticated discount investors in the market substantially increased their option market speculation that stock prices would rise throughout the bubble and then dramatically cut their option market bets that stock prices would increase after the bubble burst. • By contrast, the full-service customer open buy call volume is more stable. Moreover, the bubble appears to be essentially a non-event for the firm proprietary traders. • There is no major increase in open buy put volume, especially for full-service customers, during the bubble period. • This casts doubt on the role of short sales constraints in explaining the bubble (e.g., Ofek and Richardson (2003, JF)).

25. Table 7Percentage Impact on Daily Open Buy Call Volume of One S.D. Shock to Independent Variables

26. Value vs. Growth • Examine whether option trading behaviors are different for underlying stocks with different characteristics.

27. Table 9Large Growth Stock Average Daily Open Volume as a Percentage of Shares Outstanding

28. Table 9Large Value Stock Average Daily Open Volume as a Percentage of Shares Outstanding

29. Value vs. Growth • Discount customers became more trend chasing for growth stocks during the bubble but did not increase their activity in value stocks during the bubble.

30. Table 10: Open Buy Call Volume – During the Bubble

31. Table 11Percentage Impact on Daily Open Buy Call Volume of One S.D. Shock to Independent Variables – During the Bubble

32. Conclusion • Show that equity option market activity is a reasonably large fraction of activity in the underlying assets • Investors buy substantially more call options than put options • Investors have more short call open interest than long call open interest • Prevalence of covered call positions • Strong positive relationship between the past returns on the underlying stock and the trading volume of call options. • It appears that all three classes of investors were trend chasing past returns at various horizons.

33. Conclusion • The discount customer’s long call open interest substantially increased during the bull market, while that of other types of investors did not show such a dramatic change. • The least sophisticated segment of the market took positions based on optimistic sentiment during the height of the bubble. • For the growth stocks, the discount customers increased their long call open volume during the bubble period while other types of investors did not. For value stocks, there were no dramatic changes for all three types of investors.

34. Future Studies • Examination of equity option trading behavior around various corporate event dates and macro economic event dates. • Is the equity option market used as a way to avoid short sales constraints? • Relationship between arbitrage opportunities and option trading volume.