....About Those Put Buyers

So let's say you see some OTM puts going banana's. Big volatility lift, and of course big volume associated with it. Contrarian indicator (too much fear) on not (smart money). CXO Advisory studies the question (Hat Tip Abnormal).

Do traders with solid information about firm prospects use equity options to get leverage and avoid short selling constraints? Two recent papers address this question by testing the predictive power of distortions in out-of-the money option prices for individual stocks. In their December 2007 paper entitled "Deviations from Put-Call Parity and Stock Return Predictability", Martijn Cremers and David Weinbaum examine the power of relatively expensive options to predict returns for individual stocks. In a similar March 2008 paper entitled "What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?", Xiaoyan Zhang, Rui Zhao and Yuhang Xing focus on relatively expensive put options as indicators of bad news and poor future returns for individual stocks.

So what did they find? Here's Deviations from Put-Call parity and Stock Predictability.

A hedge portfolio reformed weekly at the market open that is long (short) stocks with relatively expensive calls (puts) earns an average value-weighted, risk-adjusted weekly abnormal return of 0.51% over the entire sample period. The relatively expensive calls (puts) make a positive (negative) contribution to this return. The return grows at a diminishing pace for longer holding periods, with no reversal.

Options with more leverage (further out-of-the-money) offer stronger predictability.

This volatility spread strategy is on average contrarian, buying stocks that have underperformed the market by 0.84% the preceding week.

Predictability seems to reflect a preference of informed traders for options over equity.

The predictive power of the volatility spread decreases over the sample period.

And the other guys?

• The options of most individual stocks exhibit some volatility smirk (elevated aversion to downside risk).


• A hedge portfolio that is long (short) stocks with the flattest (steepest) smirks, reformed weekly, generates a risk-adjusted return of about 15% per year.


• This predictability persists for at least six months.


• Firms with steepest volatility smirks (put option prices that traders have bid to relatively high levels) experience the worst negative earnings shocks the next quarter.


• Results suggest that: (1) traders with valuable negative information about a company prefer to buy out-of-the-money put options rather than short the stock, and (2) the equity market is slow to follow this signal.
  

So the obvious conclusion is that it's smart money, so follow what they do.

But before you go shorting every stock with overpriced puts, keep in mind, it's an insane strategy. Everyone saw Bear, and now everyone sees Merrill and Lehman with similar action and semi-expects a rerun. Not saying it won't happen. But just remember that it's a very crowded thought right now that may ultimately work, but strikes me as incredibly vulnerable to sudden squeezes like the recent 2-day halving and doubling in LEH.

Just for disclosure, I am long a little gamma in LEH as I mentioned on and off.