What do we know about individual equity options?

• Date: 01 January 2020
• Author: Nikolaos Voukelatos,Thanos Verousis,Alejandro Bernales,Mengyu Zhang
• DOI: http://doi.org/10.1002/fut.22066
• Published date: 01 January 2020

J Futures Markets. 2020;40:67–91. wileyonlinelibrary.com/journal/fut © 2019 Wiley Periodicals, Inc.

|

67

Received: 10 July 2018

|

Accepted: 25 September 2019

DOI: 10.1002/fut.22066

RESEARCH ARTICLE

What do we know about individual equity options?

Alejandro Bernales

1

|

Thanos Verousis

2

|

Nikolaos Voukelatos

3

|

Mengyu Zhang

2

1

Centro de Economía Aplicada and

Centro de Finanzas, DII, Universidad de

Chile, Avenida Republica 701, Santiago

Centro, Santiago, Chile

2

Essex Business School, University of

Essex, Colchester, Essex, UK

3

Kent Business School, University of

Kent, Canterbury, UK

Correspondence

Alejandro Bernales, Centro de Economía

Aplicada and Centro de Finanzas, DII,

Universidad de Chile, Calle Republica

701, Santiago Centro, Santiago 8370439,

Chile.

Email: abernales@dii.uchile.cl

Funding information

Fondo Nacional de Desarrollo Científico y

Tecnológico (Fondecyt) #, Grant/Award

Number: 1190162; Institute for Research

in Market Imperfections and Public Policy

#, Grant/Award Number: ICM IS130002

Abstract

This paper examines the empirical literature on individual equity options,

discussing results in areas of consensus, showing findings in areas of

disagreement and providing a guide for future research (especially highlighting

analyses that cannot be performed with index options). Key topics include the

impact of equity option listings on the underlying stock market, option market

efficiency, anomalies in equity option returns, option market microstructure,

investors’behavioral biases, option price discovery, and private information

revealed in equity option markets. Some directions for future research include

the determinants of equity option returns and the effect of algorithmic trading

in option markets.

KEYWORDS

empirical studies, equity options, literature survey

JEL CLASSIFICATION

G12; G13; G14; G41

1

|

INTRODUCTION

What is the current knowledge regarding individual equity options? In spite of the rapid growth of equity option

markets since the first day of trading on the Chicago Board Option Exchange (CBOE) on April 26, 1973, there has been

no effort in the financial economics literature to consolidate, in a literature review, the current knowledge and

understanding of individual equity options. The number of empirical papers examining individual equity options has

increased at a slower rate than the number examining index options. This is mainly due to problems with data

availability and relatively low trading activity observed in individual equity option markets, compared with index

options that have historically been highly traded. However, data availability and trading activity on individual equity

options have increased in the last decades, such that the volume of empirical papers on individual equity options has

now reached a level that merits a survey of this literature.

The objective of this study is to offer a systematic review of the empirical literature on individual equity options, by

discussing questions examined, data sets used, and main findings, and providing some avenues for future research. Our

survey of the equity options literature shows several research areas that have emerged, ranging from topics of relative

consensus and solid understanding, to areas where the evidence is rather mixed and more research is required.

Although a chronological literature review could highlight the historical changes in the research field, studies on

equity options span several research topics, which could make a chronological review needlessly complicated. Thus,

studies in this survey are primarily ordered thematically, to provide a big picture of the knowledge on individual equity

options. We mainly focus our attention on empirical studies where individual equity option data are used. Thus, in this

literature review, we do not consider theoretical studies, which can be applied to options with other underlying types,

such as indexes, bonds, or exchange rates. However, in some parts of this empirical literature review, we will briefly

mention theoretical advances that apply to options, as a means to better understand the results obtained in the

empirical studies on individual equity options.

Before starting our literature review on individual equity options, it is important to answer the following question:

What can we learn from empirical studies on individual equity options that we cannot learn from empirical studies on

index options? This is an important question, since its answer makes the current survey valuable and provides a

motivation for its development. There are many reasons why it is useful to analyze individual equity options rather than

index options. First, there are analyses that can be performed more cleanly with individual equity options than with

index options. For example, the analysis of the factors that affect the introduction and success (in terms of trading

activity) of new options listed for the very first time is difficult to perform with index options. This is because there are

not many listings of index options in option market history, while there are plenty of listings of individual equity

options (e.g., Bernales, 2017; Danielsen, Van Ness, & Warr, 2007; Mayhew & Mihov, 2004). For instance, on the first day

of option trading on the CBOE in 1973, individual equity options were traded on 16 stocks, and no option contracts

were traded on indexes (the first index option was introduced only 10 years later in 1983). The large number of listings

of individual equity options in the following years, compared with listings of index options, can be observed in the

current option market status. For example, in 2018, individual equity options were traded on 4,337 stocks, while index

options were traded on only 34 indexes in the United States.

1

Moreover, the large number of equity options is not only

useful for studies on option listings, but also allows researchers to perform robust cross‐sectional analyses of the impact

of option listings on the underlying assets, by controlling for specific features of the option contracts and stocks (e.g.,

trading activity, market volatility, firm industry, amongst others).

Second, in addition to topics that are difficult to examine using index options due to the very low frequency at which

certain events are observed (such as option listings as discussed above), there are other research questions where equity

options can provide a more fertile ground for analysis, due to the specific type of information that is relevant to their

trading. This is the case with some studies that examine potential information flows between the option market and the

underlying asset market (e.g., Chan, Chung, & Fong, 2002; Muravyev, Pearson, & Paul Broussard, 2013; Stephan &

Whaley, 1990). For instance, we will describe studies that show that levels of informed trading in the underlying stock

market are reduced after the introduction of equity options, which can improve the price discovery process (i.e., the

process by which information is progressively incorporated into prices). In fact, we can expect informed agents to use

their private information for trades in stocks in which they have informational advantages, which is captured in the

trading activity of stocks by market microstructure models (e.g., Duarte & Young, 2009; Easley, Kiefer, & O’Hara, 1997;

Easley, Kiefer, O’Hara, & Paperman, 1996; Easley, O’Hara, & Paperman, 1998a; Odders‐White & Ready, 2008). The

private information that agents may have on indexes is not the same in nature as the private information on a particular

stock, which makes the analysis of information flows between the option market and the underlying asset market

different. In particular, private information on a particular stock is mainly related to undisclosed news or events

regarding the firm that issued the stock, whereas private information on indexes mainly reflects some anticipated global

economic view of the market.

Third, individual equity options and index options are dissimilar in the sense that they attract different types of

investors, and thus demand for them reacts to different factors. For instance, Lemmon and Ni (2014) show that equity

options (index options) are actively traded by individual investors (sophisticated institutional investors). Lemmon and

Ni (2014) also present evidence that trading activity in equity options is related to individual investors’sentiment and

past market returns, whereas trades of index options are motivated by a hedging demand. Along similar lines, T.

Johnson, Liang, and Liu (2016) show that index options are mainly used for hedging purposes in relation to crash risks

for the whole market. As a result, findings from the literature on index options in terms of agents’behaviors cannot

necessarily be extended to the case of individual equity options.

For all the reasons described above, a systematic review of the current state of the literature on individual equity

options (which is independent of the index option literature) is both timely and particularly important. We start this

literature review in Section 2 by discussing the relationship between the equity option market and the underlying stock

market. Under the Black and Scholes (1973) assumptions, options written on individual stocks represent redundant

securities. For instance, the Black and Scholes (1973) option pricing framework is based on the property that the payoff

of an option contract can be replicated by a portfolio consisting of the underlying stock and a risk‐free bond. Thus, we

1

Information obtained from the Option Clearing Corporation web page, www.optionsclearing.com.

68

|

BERNALES ET AL.