Why Traders Prefer Options
Recent research from an academic team indicates that experienced investors generally find profitable trading opportunities before and after the release of information to the public. By their ability to predict the effect on stock values of announcements, they are able to make more profitable trading decisions.
In fact, the most successful and informed traders prefer to trade in options and other derivatives, rather than underlying equities because of the greater profit opportunities that these afford. According to the researchers, this indicates that investors who are looking to take advantage of informational insights should consider carefully which trading instruments to use to maximize their gains.
Researchers evaluated OptionMetrics news release database
To reach their conclusion, researchers examined a comprehensive archive of news releases from OptionMetrics, along with a corresponding database of option volumes around each news event. These included both options buyers and sellers, as well as cases where traders open new positions or closed existing ones. They also added volatility information into the mix.
What they found was that informed traders tend to invest in options rather than equities around scheduled market events such as earnings releases. This is something that pure options traders have suspected for some period of time.
What the researchers found
The outcome of the study was that options traders are more active than equity market traders in the lead up to and the immediate aftermath of news events. They then looked at whether these news releases actually presented traders with profit opportunities. They found that option trading volumes do have a predictive value for future changes in stock prices.
They also found that implied volatility tends to increase prior to the release of earnings announcements, and then declines quickly afterward. Because of this pattern, unexpected news events tend to reduce the profitability of trading strategies that involve taking long positions, whereas the profitability of short positions is generally increased.
Putting this into concrete terms, the researchers found that a constant level of volatility around a market event may give investors an edge if they buy calls rather than selling puts when there is a positive signal. This is due to the greater leverage that is available in the former scenario. On the other hand, an investor may do better to buy a put instead of selling a call in the events that there is a negative signal.
Conversely, if the event is in line with predictions, then the implied volatility directly after the release of news normally leads to a decline in implied volatility. If this is the case, then it may be better to use trading strategies that take advantage of short option positions. This is because these positions have greater leverage when the event is anticipated. This led the researchers to suggest that informed investors would not step into the options market in advance of news events that are anticipated – other than if they can take short positions with the expectation that the stock price after the announcement will decline.
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