New York Times: If You Know Options, You Know Stocks

[DesertCat]

[ QUOTE ]
DO options traders know more about buying and selling stocks than the rest of us?

It seems that much of the time, they do. A new study has found that a portfolio based on the preferences of options traders has consistently beaten the overall stock market. In reaching that conclusion, the study paves the way for what may be a very profitable stock-picking strategy.

....

Consider this hypothetical portfolio constructed by the professors: it held the stocks of the 20 percent of options with the lowest put-call ratios, while selling short the stocks whose options had the highest such ratios. (The portfolio was readjusted weekly, adding and deleting stocks because of changes in the ratios.)

The professors reported that before transaction costs, this portfolio produced an annual average return of 62 percent over the dozen years covered in the study. This contrasts with an annualized total return of 12.3 percent for the general stock market over this period, as measured by the Dow Jones Wilshire 5000 index. Still more impressive was the fact that the portfolio earned double-digit returns each year, even when the overall market declined.

[/ QUOTE ]

From Saturdays New York Times

[mliew]

I guess that makes sense if you think about it. Most people that trade options are people with more experience than the average investor so they are more likely to make good bets.

Do you know a good website to find put/call ratio information? I usually use Yahoo but I don't see any kind of tool like that.

[edtost]

that paper seemed suprisingly well-written and thorough.

[maxtower]

I think part of the return could be the fact that most of the stocks that are owned are not traded all that often. For example a lot of us own index funds, that we expect to rise on average, but are not concerned that some of the stocks in the fund are bad holdings. This could have the affect of keeping prices of stocks higher than they otherwise would be, forcing returns to be lower.
The option market on the other hand only has money from people actively pursuing stock price movement, so there is no "dead weight" money.

Another idea I had for the possible reason for this phenomenon was the fact that the study was done only for 11 years which encompassed a big stock boom and a big stock fall. The put to call ratios for stocks would be highest or lowest on stocks with a lot of variance (high beta) in stock price. I guess the formula would have you buying high beta stocks when the market is going crazy, and short selling high beta stocks in a strong downturn. I wonder if this method were tested during a time when the market was more flat (like the last couple years) would the experiment produce the same/similar results?
Any ideas?
A hundred of us should go in on a subscription for a year and see how it works out.
[img]/images/graemlins/smile.gif[/img]

Max

[leto333]

Bernie Schaffer has a free report that lists some notable ratio changes, but they dont do a comprehensive report.

This strategy is similar to others I have heard of. Basically, short term options players, at least on high open interest stocks, have some form of industry specific or inside information, and are using options to gain maximum leverage for thier "gamble". you of course have a base level of options buyers that are in the play due to standard fundamental or technical reasons, but the ones who contribute to the spike are usually as characterized above.

This study also includes the more conservative long term plays where macro economic fundamentalists can see the direction of the market tide and are buying leaps to maximize profits.

It is basically following the smart money, but if too many people get wise to it, the smart money will move on to something smarter.

These type of strategies, following the smart money, are feasible as long as you are wise with your money and risk management.

[mliew]

I've been doing some research into put/call ratios on schaffersresearch.com and I'm confused as to how they can claim a high put/call ratio is an indicator of strength in a stock. If there is more open interest on puts than on calls, wouldn't this be a weakness indicator (i.e. that the stock is going down)?

[OpenWheel]

The article DesertCat cited says that a high 'newly aquired' put/call ratio means weakness in the stock. Which makes sense.

The only way I could see the ratio you cite as meaning strength is if open interest behaves differently then new options. IE, as in a large number of shorts may mean covering will occur and move the price up. I have no idea otherwise, but the ratio cited by this study makes sense.

[RocketManJames]

[ QUOTE ]
I've been doing some research into put/call ratios on schaffersresearch.com and I'm confused as to how they can claim a high put/call ratio is an indicator of strength in a stock. If there is more open interest on puts than on calls, wouldn't this be a weakness indicator (i.e. that the stock is going down)?

[/ QUOTE ]

Traditonally, put/call ratio is used as a contrarian indicator. If there are a ton of people that are bullish on the stock, there's probably few buyers left (they've all bought already). And, the logic works similarly for a bearish situation.

The paper seems to contradict the traditional logic.

For those who haven't read the paper, but want to do so, it can be found on the author's personal homepage. Just do a google search for it.

-RMJ

[IronFly]

good link Desert Cat, thanks.

[Tater10]

Maybe I'm reading the article wrong, but 20% of options? This means 20% of listed options? Then I assume you short another 20% of the listed options? So you are trading 40% of all listed options, adjusted WEEKLY?

That sounds like an awful lot of trading, even knowing it wouldn't differ that much from week to week. I'd like to know what kind of returns you would get adjusting monthly or quarterly.