This paper investigates informed trading on stock volatility in the option market. We construct non-market maker net demand for volatility from the trading volume of individual equity options and find that this demand is informative about the future realized volatility of underlying stocks. We also find that the impact of volatility demand on option prices is positive. More importantly, the price impact increases by 40% as informational asymmetry about stock volatility intensifies in the days leading up to earnings announcements and diminishes to its normal level soon after the volatility uncertainty is resolved. THE LAST SEVERAL DECADES have witnessed astonishing growth in the market for derivatives. The market’s current size of $200 trillion is more than 100 times greater than 30 years ago (Stulz (2004)). Accompanying this impressive growth in size has been an equally impressive growth in variety: The derivatives market now covers a broad spectrum of risk, including equity risk, interest rate risk, weather risk, and, most recently, credit risk and inflation risk. This phenomenal growth in size and breadth underscores the role of derivatives in financial markets and their economic value. While financial theory has traditionally emphasized the spanning properties of derivatives and their consequent ability to improve risk-sharing (Arrow (1964) and Ross (1976)), the role of derivatives as a vehicle for the trading of informed investors has emerged as another important economic function of these securities (Black (1975) and Grossman (1977)). We contribute to the body of knowledge on the economic value of derivatives by investigating the role of options as a mechanism for trading on information about future equity volatility. Our focus on informed volatility trading is motivated to a large extent by the fact that equity options are uniquely suited to investors with information about future volatility. Unlike traders with

W e exploit the information in the options market to study the variations of return risk and market prices of different sources of risk during the rise and fall of the Nasdaq market. We specify a model that accommodates fluctuations in both risk levels and market prices of different sources of risk, and we estimate the model using the time-series returns and option prices on the Nasdaq 100 tracking stock. Our analysis reveals three key variations during the period from March 1999 to March 2001. First, return volatility increased together with the rising Nasdaq index level, even though the two tend to move in opposite directions. Second, although the market price of diffusion return risk averages around 1.82 over the whole sample, the estimates reached negative territory at the end of 1999. The estimates reverted back to highly positive values after the collapse of the Nasdaq market. Third, the market price of jump risk increased with the rising Nasdaq valuation, and this increase in market price coincided with an increased imbalance in open interest between put and call options.

We study the impact of derivatives trading on the investment performance of individual investors and examine whether investor performance is persistent. Using a sample of more than 68,000 accounts and nine million trades, we find that the average investor earns negative gross and net alphas, mainly because of substantial losses on derivatives investments. The underperformance of derivatives traders is due to bad market timing that results from overreaction to past stock market movements. We also find strong evidence of performance persistence among individual investors. Women are more successful investors than men and persistent winners hold larger accounts with lower turnover.

This paper investigates the motive of option trading. We show that option trading is mostly driven by differences of opinion, a finding different from the current literature that attempts to attribute option trading to information asymmetry. Our conclusion is based on three pieces of empirical evidence. First, option trading around earnings announcements is speculative in nature and mostly dominated by small, retail investors. Second, around earnings announcements, the pre-announcement abnormal turnovers of options seem to predict the post-announcement abnormal stock returns. However, once we control for the pre-announcement stock returns, the predictability completely disappears, implying that option traders simply take cues from the stock market and turn around to speculate in the options market. Third, cross-section and time-series regressions reveal that option trading is also significantly explained by differences of opinion at ordinary times. While informed trading is present in stocks, it is not detected in

U.S. exchange-traded stock options are exercisable before expiration. While put options should frequently be exercised early to earn interest, they are not. In this paper, we derive an early exercise decision rule and then examine actual exercise behavior during the period January 1996 through September 2008. We find that more than 3.96 million puts that should have been exercised early remain unexercised, representing over 3.7 % of all outstanding puts. We also find that failure to exercise cost put option holders $1.9 billion in forgone interest income and that this interest is systematically captured by market makers and proprietary firms.

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This paper provides a new perspective on the informational leading role of the option market relative to the stock market. We study the extent to which the predictive power of option implied volatilities (IVs) on stock returns lies in earnings-related or/and analyst-related corporate news. We find that our two proxies for option trading (IV skew and IV spread) significantly predict earnings surprises, analyst recommendation changes, and analyst forecast changes. Next, we find that the IV skew and spread predict stock returns, and that the degree of predictability more than doubles around earnings-related or analyst-related events. Additionally, we show that informed traders choose to use the option market particularly because of short-sale constraints on the underlying stock. We also find that the predictability of option IVs increases with the liquidity of the options. JEL Classification: G12, G14, G17.

This study follows the approach of Ni, Pan and Poteshman (2008) – based upon the vega-weighted net demand for volatility – to determine whether volatility information exists within the Taiwan options market. Our empirical results show that foreign institutional investors possess the strongest and most direct volatility information, which is realized by the delta-neutral options/futures trades. In addition, a few individual investors (less than 1 % of individuals ’ trades) might be informed and realize their volatility information using the strangle strategy. Surprisingly, we find no evidence to support the predictive ability of the volatility demand from straddle trades, despite the widespread acknowledgement that such trades are sensitive to volatility. JEL classification: G14

This paper examines the impact of option trading on individual investor performance. The results show that most investors incur substantial losses on their option investments, which are much larger than the losses from equity trading. We attribute the detrimental impact of option trading on investor performance to poor market timing that results from overreaction to past stock market returns. High trading costs further contribute to the poor returns on option investments. Gambling and entertainment appear to be the most important motivations for trading options while hedging motives only play a minor role. We also provide strong evidence of performance persistence among option traders.