Crazy Math, Illiquidity, and More Takeaways from the OptionMetrics Conference

Food for thought from the OptionMetrics conference

Oct 21, 2015 at 9:08 AM
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    I had the privilege Monday of attending the OptionMetrics Research Conference at the Intrepid Museum in New York. For those not familiar with OptionMetrics:

    "OptionMetrics is the financial industry's premier provider of quality historical option price data, tools, and analytics. Currently, over 300 institutional subscribers and universities rely on our products as their main source of options pricing, implied volatility calculations, volatility surfaces, and analytics. We enable traders to construct, test, and execute options/derivatives investment strategies and accurately monitor their risk exposure, so that they can make more informed and, ultimately, more profitable investment decisions."

    The presenters at the conference were all academic types doing some pretty sophisticated research using data provided by OptionMetrics. I can't come close to doing them justice, especially since some of the papers are not complete and published yet. I'll do my best to describe some over the week in a sec. My other takeaways are: 

    1. It takes a while to heat an aircraft carrier. That's more a physics takeaway. It felt nice, though, as it's usually like a sauna in these sort of conferences.

    2. I thought there would be no math... Or at least not math like this.




    3. I felt like the professor in "Good Will Hunting." He saw Will's math ability and pointed out that very few people in the world could see the difference between the two of them (that is, Will was a genius, and he wasn't). The problem was that he (the professor) was one of those few people who knew the difference.

    At times I tweet about earnings moves predicted by the options screen. But I only tweet out the magnitude predictions, not direction -- something like "NFLX options pricing in a 14% earnings move."

    It's not that direction doesn't matter -- rather that I don't have a great way to "predict" it. Generally speaking, I would default to "the present trend continues." That is, a strong stock into earnings will likely remain a strong stock out of earnings. But the immediate reaction might diverge. What I don't like is when someone sees high put volume or high call volume and just blindly assumes that's "smart" money and he better go chase it. Never mind that there's no context attached whatsoever.

    Anyway, that's why I found "Options Illiquidity: Determinants and Implications for Stock Returns" by Ruslan Goyenko, Chayawat Ornthanalai, and Shengzhe Tang from McGill University very interesting:

    "We study the determinants of options illiquidity measured with relative bid-ask spreads of intraday transactions for S&P 500 firms over an extended period. We find that market makers’ hedging costs significantly impact options illiquidity with the future rebalancing cost dominating the initial delta-hedging cost. Inventory demand pressure and adverse selection also contribute to variations in options illiquidity, with the latter effect intensifying around information events. We find option-induced order flows predict their underlying returns only when options illiquidity significantly increases. This suggests that shocks to options illiquidity help distinguish abnormal order flows that contain private information from those induced by liquidity trading. We show a simple strategy that trades only high-option-illiquidity stocks yields 16.5% in risk-adjusted returns per year."

    Emphasis is mine. "Private information" is, of course, a polite way of describing insider trading.

    The idea is that the one-sided order flow is only significant if it produces relative illiquidity. And that illiquidity manifests itself in wider bid-ask spreads. Long story short, the illiquidity signals a positional imbalance, and that imbalance is going to eventually resolves itself in favor of the order flow.

    They (correctly) note that options order flow isn't actually balanced to begin with. Options are for sale net-net. I can certainly attest to that from my days as a market maker. Taking the other side of order flow always got us net long just about every call on the board. I didn't find that as true with puts at all times, though I believe net-net that's correct too, as I also remember that it fit to sell any put bid with a pulse.

    So, before you go try to replicate this at home, I'd note that it's not just as simple as looking at an options screen of a stock in motion and seeing some wide quotes. You'd have to baseline quote width, normal options numbers, et. al. I'd also note earnings season is just an example. "Private information" gets used all the time. I'd also note that there are services out there that attempt to solve this riddle, but it's generally a measure of whether options are trading on the bid or ask.

    Anyway, interesting food for thought.

    Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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