Investment horizon and option market activity

• Published date: 01 May 2022
• Author: Da‐Hea Kim
• Date: 01 May 2022
• DOI: http://doi.org/10.1002/fut.22314

Received: 2 December 2021

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Accepted: 13 January 2022

DOI: 10.1002/fut.22314

RESEARCH ARTICLE

Investment horizon and option market activity

Da‐Hea Kim

SKK Business School, Sungkyunkwan

University, Seoul, Republic of Korea

Correspondence

Da‐Hea Kim, SKK Business School,

Sungkyunkwan University, 25‐2,

Sungkyunkwan‐ro, Jongno‐gu,

Seoul 03063, Republic of Korea.

Email: daheakim@skku.edu

Abstract

This paper uses a unique data set of institutional investors’equity and equity

option holdings to investigate how their investment horizons are associated

with option trading and its information content. Firms with more short‐term

investors have more active option markets relative to stock markets. Also, they

have a greater proportion of option trading volume ascribed to high‐leveraged

contracts. Furthermore, both abnormal option trading before earnings

announcements and informativeness of option market statistics are more

pronounced when short‐term investors predominate. These findings suggest

that short‐term institutions trade leveraged contracts actively to exploit

information, thus effecting price discovery in option markets.

KEYWORDS

equity options, informed trading, institutional investors, investment horizons, option trading

volume

JEL CLASSIFICATION

G12, G13, G14, G20

1|INTRODUCTION

Various strike prices and maturities of options allow investors to better align their positions to their trading motives in

incomplete real‐world financial markets (see, e.g., Black, 1975; Brennan & Cao, 1996; Hakansson, 1982; Ross, 1976).

Despite the option markets’merit of providing a broader spectrum of available trading choices, little is known about

how investors with different motives capitalize on various contractual terms of equity options. Because the efficacy of

equity option markets depends on how investors actually use equity options, uncovering the relation between investor

characteristics and equity option market activity is important to understanding the role of equity option markets.

The purpose of this study is (1) to examine the relation between investors’expected holding periods and trading

activity of equity options and (2) to provide its implications for the informational role of equity option markets. We

focus on investors’investment horizons as a cross‐sectional determinant of option trading activity for two main

reasons. First of all, the investment horizon is expected to capture the likelihood of information‐based trading. Spe-

cifically, short‐term investors are more likely to trade on information than long‐term investors, because the short‐lived

nature of any informational advantage forces traders with private information to trade fast and aggressively to preempt

the informational advantage (e.g., Massa et al., 2015; Yan & Zhang, 2009). Given that high leverage achievable with

options attracts informed traders (e.g., Black, 1975; Easley et al., 1998), the greater inclination of short‐term investors

toward information‐based trading implies that short‐term investors are more likely to choose option markets over stock

markets as their trading venues than long‐term investors. Moreover, in choosing among different option contracts,

short‐term investors are more likely to prefer high‐leveraged contracts to exploit private information to great

J Futures Markets. 2022;42:923–958. wileyonlinelibrary.com/journal/fut © 2022 Wiley Periodicals LLC

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advantage. Thus, to the extent that investors with different investment horizons are heterogeneously involved in

information‐based trading, investment horizons would affect option trading and its informational role.

Second, the investment horizon would relate to investors’hedging needs. Since an asset value is more volatile and

harder to predict in the long run than in the short run from an investor's perspective, long‐term investors are more

exposed to unwanted price movements and uncertainty than short‐term investors (e.g., Bodie, 1995; Pastor

& Stambaugh, 2012). Moreover, since long‐term investors tend to have substantial shares of their capital tied to a single

firm (e.g., Bushee, 2001), they are likely to bear high firm‐specific risk. Therefore, long‐term investors are more likely to

use options primarily for hedging than short‐term investors. Considering that hedgers, as compared to informed

traders, may want to avoid risky positions (Roll et al., 2009), long‐term investors are more likely to choose

less‐leveraged options than short‐term investors. In this way, investors with different investment horizons are likely to

be differentially motivated to hedge and thereby exhibit different trading behaviors in option markets.

To estimate the investment horizons of traders in equity option markets, we focus on institutional investors for two

reasons. First of all, institutional investors comprise the largest proportion of those trading in the US equity option

markets. For example, according to Pan and Poteshman (2006), about 80% of total option trading volume comes from

institutional investors.

1

Second, the availability of data on institutional security holdings offers a unique opportunity to

infer their expected holding periods from actual trading behavior. The US Securities and Exchange Commission (SEC)

requires all sizable institutional investors to submit Form 13F, a quarterly report that discloses their quarter‐end

portfolio holdings in public companies. By retrieving all original Form 13F filings available from the SEC, we obtain

institutional holdings not only in common stocks but also in individual equity options, the latter of which is usually

excluded from the standard database. The data on equity option holdings are vital to this study since the analysis in the

study involves identifying option market participants and estimating their portfolio turnovers. We define institutional

option users as the institutions who report at least one option position and then estimate their portfolio turnover using

their security holdings. Institutional option users are classified as short‐term investors if they change their holdings

relatively frequently and as long‐term investors if they keep their holdings for a relatively long period.

The empirical analysis in this paper shows that option market activity varies significantly with investors’invest-

ment horizons. Specifically, we find that firms with more short‐term investors have more active option markets relative

to stock markets. For example, when we sort firms into quintiles based on an investment horizon proxy, firms with the

greatest share of short‐term investors have the average ratio of total option market dollar volume to total stock market

dollar volume of 0.70%, while firms with the least have the average option to stock volume ratio of 0.30%. The spread of

0.40% in the average option to stock volume ratio between the extreme quintiles corresponds to the interquartile range

of the option to stock dollar volume ratios, thus implying large economic significance. Also, as for the distribution of

option trading activity across different contractual terms, the proportion of option trading volume accounted for by

high‐leveraged contracts such as out‐of‐the‐money options is significantly higher for firms with more short‐term

investors. Thus, the relation between the investment horizon and option market activity shows that investors with

shorter expected holding periods are more likely to choose option trading over stock trading, and moreover, they prefer

high‐leveraged option contracts, consistent with the motivation to exploit information.

Having established that the investment horizon is an important source of cross‐sectional variation in option market

activity, the paper turns to examine how the investment horizon is related to the informational role of option markets

by conducting two kinds of analysis. First, by focusing on days before earnings announcements, we investigate an

association between the investment horizon and the extent of informed trading in option markets. Amin and Lee

(1997) report that option open interest increases substantially immediately before earnings announcements, suggesting

that informed traders initiate option positions in anticipation of earnings news. We find that the abnormal increase in

the pre‐announcement open interest is positively associated with the preponderance of short‐term investors in market

participants. Moreover, the ratio of put open interests to call open interests predicts earnings news only when short‐

term investors predominate. The findings imply that short‐term investors trade options proactively to take advantage of

their private information before the release of important firm‐specific news.

1

Using a unique data set which contains the detailed daily open interest and volume of equity options listed at the Chicago Board Options Exchange

from 1990 through 2001, Pan and Poteshman (2006) provide a description about the option trading of investors classified into firm proprietary

traders, public customers of full‐service brokers, and public customers of discount brokers. Table 1 in Pan and Poteshman (2006) shows that about

80% of total trading volume is due to full‐service customers, which correspond to institutional investors. Lakonishok et al. (2007) report similar

figures for open interest in Table 1.

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Second, we analyze how the investment horizon is associated with the ability of option prices to predict stock price

movements in normal times. Xing et al. (2010) show that the difference of option implied volatility between out‐of‐the‐

money puts and at‐the‐money calls, or the volatility skew, foreshadows underlying stock returns. Also, Cremers and

Weinbaum (2010) find that the difference of implied volatility between a pair of call and put options with the same

strike price and maturity date, or the volatility spread, predicts stock returns. The analysis in this paper shows that

the stock return predictability of the option volatility skew and spread is much stronger when short‐term investors

predominate in option market participants. This finding supports the idea that short‐term investors, as opposed to long‐

term investors, play a role in facilitating price discovery in option markets.

This study contributes to the literature in three ways. First, to our knowledge, this study is the first to empirically

examine the source of cross‐sectional variation in option market activity across different contractual terms. Roll et al.

(2010) show how aggregate trading volume in a firm's equity options is related to firm characteristics. The distribution

of a firm's option trading volume across moneyness and maturity, however, exhibits substantial variation. While Roll

et al. (2010) focus on investors’choices between trading options and trading equities, we additionally explore the

choices among options of different strike prices and times to expiration. By showing that investors’investment horizons

help explain variation in option trading across different contractual terms as well as the overall option trading level,

this study broadens our understanding of equity option market activity.

Second, this paper extends the literature on the informational role of equity option markets by showing how the

informational content of option markets hinges on investor characteristics. Many empirical studies find that the

statistics observed in equity option markets predict stock market movements, suggesting informed trading in option

markets.

2

However, empirical evidence on who informed traders are and how they trade to exploit their informational

advantage in option markets is still limited.

3

This study shows that informativeness of the option market signals is

negatively related to the investment horizon of institutional investors, indicating that short‐term institutional investors

are instrumental in effecting price discovery and dissemination of information in option markets.

Finally, this paper complements a scant literature on the derivatives use by institutional investors. Despite the

centrality of institutional investors in equity option markets, less is known about how characteristics of institutional

investors relate to the trading behavior in option markets. Most studies of institutions’derivatives usage concentrate on

differences between derivatives users and nonusers in subsets of institutions.

4

The lack of research on institutions’

option market activity is partly due to the difficulty of obtaining the relevant data. In this study, we gain all 13F

institutions’option holdings data via web scraping. Using this data set, we identify option users from the entire

universe of the institutions and then differentiate between short‐term and long‐term investors based on their portfolio

turnover. By showing that the relative importance of short‐term and long‐term institutional investors in option markets

influences the level and the distribution of option trading activity and its information content, we shed light on the

different option uses of short‐term and long‐term institutional investors.

The remainder of the paper is organized as follows. Section 2provides predictions for how investors with different

expected holding periods choose to trade in equity option markets. Section 3describes data and variables used in the

2

For example, Easley et al. (1998) report that signed option volume—that is, positive option volume (i.e., volume for long calls and short puts) or

negative option volume (i.e., volume for short calls and long puts)—conveys the information on the contemporaneous stock price. C. Cao et al. (2005)

find that the call volume imbalance (i.e., difference between buyer‐and seller‐initiated volumes) of a target firm predicts takeover announcement

returns. Pan and Poteshman (2006) show that the ratio of put to call option volume initiated by buyers to open new positions foreshadows stock price

movement. Bali and Hovakimian (2009) and Cremers and Weinbaum (2010) find that the difference in implied volatility between pairs of call and

put options (i.e., volatility spread) predicts stock returns. Also, Xing et al. (2010) indicate that the slope of the implied volatility curve (i.e., volatility

skew) forecasts stock returns. Johnson and So (2012) reveal that the ratio of total option market volume to total stock market volume has predictive

power for future stock returns.

3

Pan and Poteshman (2006) find that the put‐call ratio constructed from trading volume by full‐service brokers’customers has greater predictability

for stock returns than the one constructed from trading volume by discount brokers’customers, suggesting that full‐service brokers’customers are

informed traders in option markets. This study complements their finding by refining the full‐service customers according to the investment

horizons. Also, Collin‐Dufresne et al. (2021) focus on trades by Schedule 13D filers and find that large activist shareholders rarely trade in option

markets to exploit their private information. Considering that large activist shareholders are typically long‐term dedicated investors, their finding is

consistent with our finding that short‐term investors, as opposed to long‐term investors, are informed traders in option markets.

4

For example, Deli and Varma (2002) and Almazan et al. (2004) show that a mutual fund's use of derivatives is related to trading costs and agency

problem, implying that a fund's decision to use derivatives accords with trading efficiency and optimal contracting. Koski and Pontiff (1999) and Cici

and Palacios (2015) report that derivatives users and nonusers in the mutual fund industry have similar risk exposure and performance. In contrast,

Natter et al. (2016) report that option use leads to higher returns and lower systematic risk in mutual fund industry. Y. Chen (2011) and Aragon and

Martin (2012) show that hedge funds using options deliver superior performance (i.e., higher returns and lower risk) than nonusers.

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