Because of the complexity of options trading, the options market is presumably dominated by more sophisticated investors than an average stock investor. However, when options investors let their emotions get the best of them, they can impact the implied volatility spread between call and put options (CPIV), leading to option mispricing and very low returns. The question then becomes how to successfully trade options when CPIV is affected.
James S. Doran, a hedge fund manager at Implied Capital Advisors; Andy Fodor of Ohio University, and Danling Jiang of Florida State University, using OptionMetrics data, found the answer if to profitability when CPIV is changed in their research, Call-Put Implied Volatility Spreads and Option Returns, published in the Review of Asset Pricing Studies.
Prior research finds that the CPIV, which measures the relative expensiveness between calls and puts, is a positive signal for the underlying stock returns. However, the team found that the CPIV is a negative signal for the future returns on out-of-the-money (OTM) call options. These researchers recommend using a delta hedging covered call strategy (offsetting long andshort positions to reduce the risk associated with price movements in theunderlying asset) to greatly improve returns. But first, traders need to understand how behavior affects the CPIV.
While researching the movement of CPIV, the team found a significant difference between the effects customer investors (or trades done on behalf of retail clients) have on CPIV versus the effects institutional investors have on it. Customer investors who purchase the OTM call options using favorable private information or who follow institutional investors often overbuy. As a result of such suboptimal behavior, OTM call options become overly expensive and the CPIV moves higher. This movement negatively impacts returns on these overbought OTM call options.
In contrast, when institutional investors purchase call options in response to favorable private information about the underlying stocks, their demand primarily drives the CPIV of at-the-money (ATM) options higher. The higher CPIV of the ATM options due to institutional demand precedes higher subsequent underlying stock returns but not lower subsequent ATM call option returns. In other words, institutional option investors often properly use private information, but retail option investors do not. Conversely, the researchers found very little predictability for OTM and ATM put options.
Based on these findings, option traders can use a delta hedged options strategy to profit from suboptimal trading behavior of unsophisticated option investors. This strategy will allow them to earn much higher returns over time relative to the market and a regular long/short equity strategy.
To arrive at these findings, researchers formed delta-hedged covered call portfolios for both ATM and OTM call options by using the OptionMetrics data. The portfolios were rebalanced daily and had a 26-day holding period for the given CPIV measure. As shown in the chart above, they found a positive – and significant – delta-hedged return when traders sell call options of high CPIV firms and buy call options of low CPIV firms. This strategy is more profitable for OTM than for ATM call options.
