The Option Volume to Stock Volume Ratio, Market Efficiency and Future Returns

Abstract: The study of the information value in options has for decades been at the centre of financial research. Recent findings indicate that informed investors prefer to use options to trade on negative information, causing the option volume to stock volume ratio (O/S) to correlate negatively with future returns. Drawing from evidence on mispricing in illiquid markets, this study develops a multimarket model that incorporates price inefficiencies that arise from low levels of liquidity into the O/S framework. In the presence of short sale costs, the model predicts that O/S is more strongly negatively correlated with future returns for firms with low levels of liquidity compared to firms with high levels of liquidity. Using a large sample of cross-sectional and time-series data on US listed stocks and options, this study finds strong empirical support of the model's prediction. We additionally derive a self-financing trading strategy that is based on our empirical results and find that the strategy generates weekly four-factor alphas of 0.53% and CARs of 230.31% during the 2002-2012 period. Thus, we conclude that the linkage between O/S, illiquidity and future stock performance is of high economic significance.