Index options open interest and stock market returns

• DOI: http://doi.org/10.1002/fut.22095
• Published date: 01 June 2020
• Author: Sung Won Seo,Suk Joon Byun,Jun Sik Kim
• Date: 01 June 2020

J Futures Markets. 2020;40:989–1010. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals, Inc.

|

989

Received: 28 February 2018

|

Accepted: 31 December 2019

DOI: 10.1002/fut.22095

RESEARCH ARTICLE

Index options open interest and stock market returns

Sung Won Seo

1

|

Suk Joon Byun

2

|

Jun Sik Kim

3

1

Department of Business Administration,

Konkuk University, Gwangjin‐gu, Seoul,

Republic of Korea

2

College of Business, Korea Advanced

Institute of Science and Technology,

Dongdaemoon‐gu, Seoul, Republic of

Korea

3

Division of International Trade, Incheon

National University, Yeonsu‐gu, Incheon,

Republic of Korea

Correspondence

Jun Sik Kim, Division of International

Trade, Incheon National University, 119

Academy‐ro, Yeonsu‐gu, Incheon 22012,

Republic of Korea.

Email: junsici@inu.ac.kr

Funding information

Incheon National University Research

Grant in 2016

Abstract

This study finds that the growth of index options open interest has a significant

relation with future stock market returns. We propose a theoretical model that

considers hedgers and informed traders in the options market and suggests that

hedgers fully utilize options according to their expectations of future stock

returns. The empirical results show that the growth of out‐of‐the‐money call

options open interest is significantly related with future stock market returns.

These findings provide supporting evidence for our theoretical model.

KEYWORDS

open interest, options market, stock market returns

JEL CLASSIFICATION

E31; G12; G13

1

|

INTRODUCTION

Derivatives play an important role in financial markets as they are useful for making various payoffs based on the

direction and magnitude of investors' predictions. Thus, numerous studies have investigated information in the options

market and the lead–lag relation between the stock and options markets. These studies present a theoretical framework

and find empirical evidence that informed traders prefer to first trade in the options market so as to fully exploit their

private information using the financial leverage of options (C. Chang, Hsieh, & Lai, 2009; Pan & Poteshman, 2006; Roll,

Schwartz, & Subrahmanyam, 2010; Vijh, 1990).

1

Such informed trading ensures that options trading volumes or implied

volatilities are informative enough to predict future stock returns. However, to the best of our knowledge, very few

studies have focused on the open interest of index options. To fill this gap, the current study investigates the

information content of open interest in the index options market.

The literature on the options market usually focuses on informed investors (Black, 1975; Easley, O'Hara, & Srinivas,

1998; Johnson & So, 2012; Pan & Poteshman, 2006). This study incorporates hedgers in options markets into its

theoretical model. It also investigates the effect of informed trading and hedging activities on the relation between index

options open interest and future stock market returns. The model assumes that hedgers utilize options with a strike

price corresponding to their expected stock market index level to minimize the variance of their total profit. Thus,

hedgers prefer to take positions in not only out‐of‐the‐money (OTM) options, but also in‐the‐money (ITM) options,

depending on expectations of future stock market returns; consequently, the open interest of ITM and OTM options

becomes informative about future stock market returns with a proper mass of informed traders and hedging demand.

1

Recent empirical studies that focus on information provided by options' implied volatility or price to predict future stock price movements include An, Ang, Bali, and Cakici (2014), Cremers and

Weinbaum (2010), Doran and Krieger (2010), Han, Kim, and Byun (2017), and Xing, Zhang, and Zhao (2010).

This study's empirical results show that growth of OTM call options open interest has a significant positive relation with

future stock market returns. Our findings confirm that the growth of index options open interest provides valuable

information on future stock market returns. Further, this study provides evidence supporting informed trading in the

options market as active with hedgers and informed traders.

This study examines hedgers' activities and informed trading in the index options market by focusing on growth of

the index options open interest. It empirically investigates the relation between the growth of each type of options open

interest and stock market excess returns based on the significance of the coefficient estimate and improvement in

adjusted R

2

in the regression. Using the Standard & Poor's (S&P) 500 index and options, we find that the growth of OTM

call options open interest has a positive relationship with future stock market excess returns. Although the growth of

open interest in other options (ITM call, ITM put, and OTM put) does not present significant results, the direction of

prediction with the growth of open interest in other options for future stock market returns is consistent with our

model. Thus, our findings imply that hedging demand does exist in options market; however, it is not as strong as it is in

the futures market. We conjecture that the main reasons for the insignificance of ITM call, ITM put, and OTM put are

illiquidity and overdemand. The empirical results are robust with the addition of information from options trading

volume and futures market variables, as well as analysis during the subsample period. The robustness of the results is

also checked against different filtering criteria for trading volume and open interest of options, against the weighting

methodology used to determine the growth of options open interest, and against controlling for other related variables,

such as growth of the call‐to‐put options open interest ratio, call‐to‐put options volume, deepness of moneyness, and

control of the growth of other options open interest.

2

Hong and Yogo (2012) study futures open interest in terms of asset returns. They propose an equilibrium model,

including hedgers, speculators, and uninformed investors. In their model, hedgers take long or short positions in

futures to minimize their profit from spot positions and hedging activity. When hedgers expect the economy to get

better, demand for futures increases due to hedging for an increase in production. This leads to increases in open

interest. Therefore, if the open interest of futures increases in Hong and Yogo's (2012) model, asset prices are expected

to increase following economic expansion. In addition, their empirical results support the argument that hedging

activities have a strong impact on the futures market. They find a significantly positive relation between growth in the

open interest of futures and asset returns in the commodity, currency, bond, and stock markets.

Open interest in the options market has received relatively little attention.

3

Bhuyan and Chaudhury (2005) examine

information in the distribution of the options open interest for individual stocks. They regard the distribution of options open

interest across various strike prices as a proxy for the true or physical distribution of individual stock prices at option

maturity. Their results show that trading strategies based on options open interest yield higher returns than those based on

the S&P 500 index or the buy‐and‐holdstrategy.Fodor,Krieger,andDoran(2011)useachangeinopeninterestofthecall‐

and‐put options as a predictor of future equity returns in individual stocks. Their empirical results show that an increase in

call options open interest predicts increased equity returns. They also suggest that an increase in put options open interest

predicts decreased equity returns, but the predictive power of put options open interest becomes weak after controlling for

numerous factors. Malamud, Tseng, and Zhang (2017) investigate information in commodity options volume and open

interest. They provide a model that captures the relation between informed trading, options prices, and options open interest

to find the significance of options open interest for future commodity returns.

To the best of our knowledge, this study is the first of its kind to examine the relation between the growth of open

interest in index options and future stock return movements of the aggregate market portfolio. Thus, it sheds light on

information in the index options open interest concerning future stock market returns. Although Hong and Yogo (2012)

investigate the effect of hedgers in the futures market, there is scant research on hedgers in the options market. In this

study, we consider hedgers in the options market with informed traders.

The rest of the paper is structured as follows. Section 2 outlines a model in which the growth of open interest in the

options market predicts aggregate stock market returns. Section 3 describes the data set and empirical methodology for

the growth of options open interest. Section 4 presents the main empirical findings. Section 5 represents the robustness

tests for the empirical results. Section 6 concludes.

2

Muravyev, Pearson, and Pollet (2018) suggest that profits from many investment strategies significantly reduce after considering stock borrowing fees. Whereas they study individual stocks, we focus

on index portfolios. The fees for using futuresor ETFs of indexes are much smaller than borrowing fees of individual stocks (CME Group, 2016). Thus, concerns about fees are restrictive for our results.

We are grateful to the editor for the comment.

3

See, for example, Chesney, Crameri, and Mancini (2015), Jayaraman, Frye, and Sabherwal (2001), and Schachter (1988).

990

|

SEO ET AL.