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1 – 10 of over 41000Short option positions carry significant risk of losses well in excess of 100 per cent of the initial option price. Margin requirements associated with such positions are…
Abstract
Purpose
Short option positions carry significant risk of losses well in excess of 100 per cent of the initial option price. Margin requirements associated with such positions are therefore considerable. The purpose of this paper is to develop a methodology for calculating margin requirement‐based option portfolio returns that realistically represent the returns realized by investors, and to demonstrate the effects of this methodology on analyses of option returns.
Design/methodology/approach
A methodology is developed for calculating margin requirement‐based short option portfolio returns.
Findings
Accounting for margin requirements reduces the returns of simple short option strategies by up to 92 per cent compared to the price return. In long/short portfolio analyses, use of margin requirement returns necessitates additional methodological adjustments to ensure that unwanted volatility risk is properly hedged.
Originality/value
The result is a portfolio return that more accurately represents the return realized by investors, and increased power to detect cross‐sectional patterns in option returns.
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Spencer Case and Janet D. Payne
In this paper, the authors aim to test the assertion that options act as a substitute for short sales by allowing investors an alternative way to act on bearish sentiment. An…
Abstract
Purpose
In this paper, the authors aim to test the assertion that options act as a substitute for short sales by allowing investors an alternative way to act on bearish sentiment. An empirical test of this assertion requires a researcher to observe both types of firm – those that weren’t short sale constrained, as well as those that were. The authors examine the ability of options to alleviate the short sales constraint directly – in an environment where the constraint is likely to differ across firms in a systematic fashion, namely the market for American Depository Receipts (ADRs).
Design/methodology/approach
The authors examine 190 option introductions on ADRs over the period of 1982 to 2006. The question of how ADRs are chosen for options listing, and whether those criteria differ from those found using purely domestic options, is addressed using logistic regressions. The authors use the event study methods of Brown and Warner to examine the price effect of the listing. They use OLS regression to identify determinants of the cumulative abnormal return upon option listing. Independent variables are those indicated by existing literature that examines option listing on domestic securities.
Findings
In an environment where the effective short sale constraint varies across firms, the authors find support for the contention that US option listings reduce the effect of the short sales constraint, providing relief for investors who have negative sentiment about the stock and are subject to a short sale constraint. However, it does not appear that option listing entities seek out companies for which short sale constraints are stronger.
Originality/value
The authors’ hypotheses are similar to those of Mayhew and Mihov and of Danielson and Sorescu, but the authors assert that the ADR market is a more robust environment in which to test the hypotheses. This is due to the potentially large variation in the effective short sale constraints that results from the differences in their underlying home market legal and regulatory environments. In addition to relative short interest and the change in relative short interest, this environment allows the authors to use indicator variables to directly test the ability of options to substitute for short sales.
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Using the next-day and next-week returns of stocks in the Korean market, we examine the association of option volume ratios – i.e. the option-to-stock (O/S) ratio, which is the…
Abstract
Using the next-day and next-week returns of stocks in the Korean market, we examine the association of option volume ratios – i.e. the option-to-stock (O/S) ratio, which is the total volume of put options and call options scaled by total underlying equity volume, and the put-call (P/C) ratio, which is the put volume scaled by total put and call volume – with future returns. We find that O/S ratios are positively related to future returns, but P/C ratios have no significant association with returns. We calculate individual, institutional, and foreign investors’ option ratios to determine which ratios are significantly related to future returns and find that, for all investors, higher O/S ratios predict higher future returns. The predictability of P/C depends on the investors: institutional and individual investors’ P/C ratios are not related to returns, but foreign P/C predicts negative next-day returns. For net-buying O/S ratios, institutional net-buying put-to-stock ratios consistently predict negative future returns. Institutions’ buying and selling put ratios also predict returns. In short, institutional put-to-share ratios predict future returns when we use various option ratios, but individual option ratios do not.
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This study delves into the nuanced implications of short-sale constraints on stock prices within the context of stock market efficiency. While existing research has explored this…
Abstract
Purpose
This study delves into the nuanced implications of short-sale constraints on stock prices within the context of stock market efficiency. While existing research has explored this relationship, inconsistencies persist in their findings. The purpose of this study is to conduct a comprehensive review of literature to elucidate the reasons behind these disparities.
Design/methodology/approach
A systematic review of existing theoretical and empirical studies was conducted following the PRISMA method. The analysis centered on discerning the factors contributing to the divergence in projected stock prices due to these constraints. Key areas explored included assumptions related to expectations homogeneity, revisions, information uncertainty, trading motivations and fluctuations in supply and demand of risky assets.
Findings
The review uncovered multifaceted reasons for the disparities in findings regarding the influence of short-sale constraints on stock prices. Variations in assumptions related to market expectations, coupled with fluctuations in perceived information uncertainty and trading motivations, were identified as pivotal factors contributing to differing projections. Empirical evidence disparities stemmed from the use of proxies for short-sale constraints, varied sample periods, market structure nuances, regulatory changes and the presence of option trading.
Originality/value
This study emphasizes the significance of not oversimplifying the impact of short-sale constraints on stock prices. It highlights the need to understand these effects within the broader context of market structure and methodological considerations. By delineating the intricate interplay of factors affecting stock prices under short-sale constraints, this review provides a nuanced perspective, contributing to a more comprehensive understanding in the field.
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Robert Martin Hull, Sungkyu Kwak and Rosemary Walker
The article aims to explore if stock derivative types (stock options and stock warrants) are associated with stock returns for firms undergoing seasoned equity offerings (SEOs).
Abstract
Purpose
The article aims to explore if stock derivative types (stock options and stock warrants) are associated with stock returns for firms undergoing seasoned equity offerings (SEOs).
Design/methodology/approach
The authors regress stock returns against stock derivatives for periods around SEO announcements with standard errors clustered at the month level.
Findings
The authors find that lower stock derivatives holdings for the fiscal year after the SEO are associated with superior pre-SEO returns. This can be explained by owners exercising their derivatives to capitalize on the pre-SEO price run-up. The authors find that greater stock option holdings by insiders for the fiscal year after the SEO are associated with superior post-SEO returns for up to ten years after the SEO announcement. This new finding does not hold for stock warrants.
Research limitations/implications
Stock derivatives are supplied by Capital IQ. Given their description, the authors infer that stock options are owned largely by insiders. Thus, the insider conclusions for stock options depend on this implication.
Practical implications
Stock options and stock warrants can be used strategically to reward stock derivative owners of strong performing firms for past performance. Stock options can be used to motivate insiders (primarily key executives) to achieve superior future performance.
Originality/value
This study is unique in comparing the influence of holdings for stock options and stock warrants on stock price performance around SEOs. The authors show that the sign of the association depends on whether the test includes pre-SEO periods.
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Sees the objective of teaching financial management to be to helpmanagers and potential managers to make sensible investment andfinancing decisions. Acknowledges that financial…
Abstract
Sees the objective of teaching financial management to be to help managers and potential managers to make sensible investment and financing decisions. Acknowledges that financial theory teaches that investment and financing decisions should be based on cash flow and risk. Provides information on payback period; return on capital employed, earnings per share effect, working capital, profit planning, standard costing, financial statement planning and ratio analysis. Seeks to combine the practical rules of thumb of the traditionalists with the ideas of the financial theorists to form a balanced approach to practical financial management for MBA students, financial managers and undergraduates.
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W. Paul Spurlin, Bonnie F. Van Ness and Robert Van Ness
The purpose of this paper is to study short sales trading as part of the New York Stock Exchange (NYSE) batch open and National Association of Securities Dealers Automated…
Abstract
Purpose
The purpose of this paper is to study short sales trading as part of the New York Stock Exchange (NYSE) batch open and National Association of Securities Dealers Automated Quotations (NASDAQ) opening cross. The paper examines whether short transactions at the open can predict future returns.
Design/methodology/approach
The study tests to see if short transactions in the NYSE opening batch trade and NASDAQ opening cross are informative of future returns.
Findings
It is found that a stock's opening‐trade short volume is predictive of its short volume for the rest of trading day, positively related to its previous‐day price change, and positively related to its overnight price change at the opening trade on option‐expiration Fridays when the stock is part of the Standard and Poor (S and P) 500 index.
Originality/value
While previous research shows that intraday short sale trades are informative, this is the first paper to examine the opening trade of the day, and whether these short sales are informative.
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Informed traders may prefer the options market to the stock market for reasons including the leverage effect, transaction costs, restrictions on short sale. Many studies try to…
Abstract
Informed traders may prefer the options market to the stock market for reasons including the leverage effect, transaction costs, restrictions on short sale. Many studies try to predict future returns of stocks using informed traders' behavior in the options market. In this study, we examine whether the trading volume ratios of single stock options have the predictive power for future returns of the underlying stock. By analyzing the stock price responses to the “preliminary announcement of performance” of 36 underlying stocks on the Korea Exchange from November 2014 to March 2021 and the trading volume of options written on those stocks, we investigate the relation between the option ratios, which are the call option volume to put option volume ratio (C/P ratio) and the option volume to stock volume ratio (O/S ratio), and the future returns of the underlying stock. We also examine which ratio is better in predicting the future returns. The authors found that both option ratios showed the statistically significant predictability about future returns of the underlying stock and that the return predictability of the O/S ratio is more robust than that of the C/P ratio. This study shows that indicators generated in the options market can be used to predict future underlying stock returns. Further, the findings of this study contributed to a dearth of literature pertaining to single stock options. The results suggest that the single stock options market is efficient and influences the price discovery in the stock market.
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The Treynor and Mazuy framework is a widely used return-based model of market timing. However, existing corrections to the regression intercept can be manipulated through…
Abstract
Purpose
The Treynor and Mazuy framework is a widely used return-based model of market timing. However, existing corrections to the regression intercept can be manipulated through derivatives trading. Because they are conceptually flawed, these corrections produce biased performance measures. This paper aims to get back to Henriksson and Merton’s initial idea of option replication to overcome this issue and adapt the market timing model to various kinds of trading strategies and return-generating processes.
Design/methodology/approach
This paper proposes a theoretical adjustment based on Merton’s option replication approach adapted to the Treynor and Mazuy specification. The linear and quadratic coefficients of the regression are exploited to assess the cost of the replicating option that yields similar convexity for a passive portfolio. A similar reasoning applies for various timing patterns and in multi-factor models.
Findings
The proposed framework induces a potential rebalancing risk and involves the delicate issue of choosing the cheapest option. This paper shows that these issues can be overcome for reasonable tolerance levels. The option replication approach is a workable approach for practical applications.
Originality/value
The adaptation of Merton’s reasoning to the Treynor and Mazuy model has surprisingly never been proposed so far. This paper has the potential to correct for a pervasive bias in the estimation of the performance of a market timer in the context of this very popular quadratic regression setup. Because of the power of the option replication approach, the reasoning is shown to be applicable to multi-factor models, negative timing and market neutral strategies. This paper could fuel empirical studies that would shed new light on the genuine market timing skills of active portfolio managers.
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