Stock patterns hint at valuable clues for options traders
• 6 mins read
A continuous performance of stock price can reveal a predictable pattern that benefits options traders
Stock markets swing up and down, and timing these moves to the advantage of investors is no easy task. Managing risk becomes especially important when heightened volatility cascades into further swings. While stock trading is already well-known, a side venture called stock options trading can be as good as or, sometimes, a better investment.
Stock options are financial contracts that allow the holder to buy or sell listed stocks at a specified price. Just like other financial derivatives, these options can be bought or sold. Traders can earn significant profits from price movements of the underlying equities using call and put options. A call option allows them to buy equities at a certain price, typically when they believe the stocks will rise. If they see the stocks may fall, put options will enable them to sell equities at a predetermined price. The question is, how can traders choose their options wisely?
“When talking about investment, understanding the determinants of expected option return is naturally the first step,” says Li Gang, Assistant Professor of Finance at the Chinese University of Hong Kong (CUHK) Business School. “While how stock return autocorrelation affects the stock market has been broadly studied in the literature, its impact on the options market is largely unknown.”
The traditional Black-Scholes model assumes stock price volatility stays constant and implies that stock returns are independent over time. However, in a recent research, Professor Li and his collaborators revealed that stocks that follow more predictable patterns tend to generate better returns on their stock options. If investors can spot stocks with consistent price movement patterns, their options might be more profitable.
The study underscores the importance of understanding how stock prices relate to their past movements. It helps investors better grasp market behaviour, which in turn helps them manage risk and make smarter investment decisions.
It is worth noting that stock options are also given by startups and private companies to their employees as equity compensation when the companies go public. Not to be confused with listed stock options, employee stock options cannot be traded on the open market.
How to match options with good stocks
Stock markets, in theory, should be efficient and any predictable patterns would quickly disappear as traders jump on them. But in the real world, stocks often do follow patterns, mainly due to how people trade, how quickly information spreads and the mechanics of how markets work.
“Compared with other existing option return predictors, we find our variable of stock return autocorrelation achieves one of the best performances.”
Professor Li Gang
In a paper titled Stock return autocorrelations and expected option returns, Professor Li, along with Jeon Yoontae of McMaster University and Raymond Kan of the University of Toronto, looked at how stock prices moved over time by analysing daily returns across 250-day periods. These returns included either profits or losses.
The researchers specifically focused on how today’s stock price movement might influence tomorrow’s price. The researchers also examined stock returns with high autocorrelation, which means stocks that performed well or poorly and kept doing so in the near future, and those with low autocorrelation, referring to stocks with past returns not associated with their future performances.
Examining the stock options data from a US financial data provider, OptionMetrics, spanning from 1996 to 2020 with an average of 1,674 firms exercising their options monthly, the researchers discovered that stock options with a higher autocorrelation or more predictable patterns make more profit each month compared to those with a lower autocorrelation.
The numbers were impressive. Call options on stocks with high autocorrelation showed a 3.7 per cent higher monthly return than stocks with low autocorrelation. The return is even bigger for put options at 6.4 per cent. These differences are good enough to be considered reliable, not just random luck.
What makes these findings solid is that the pattern stood up to rigorous testing, even when accounting for other factors that typically influence option returns, such as market volatility and liquidity. The researchers further verified their results through several different analytical methods, including portfolio sorting analysis, robustness checks and regression analysis.
Finding the pattern amid the crowds
The research showed that the way stocks repeat patterns over time is a better predictor of option performance than traditional indicators. While factors like market volatility may push calls and put options in opposite directions, stock return autocorrelation affects both types of options in the same way.
This makes stock patterns statistically and economically more significant than other predictors. “Compared with other existing option return predictors, we find our variable of stock return autocorrelation achieves one of the best performances. Moreover, stock return autocorrelation is very easy to compute,” adds Professor Li.
The study suggests option traders can tap into this effect in several ways, including through straddle strategies, where they buy both call and put options on the same stock at the same time. When traders focused on stocks with high autocorrelation, their straddle portfolios were found to earn 4.3 per cent more per month compared to those target stocks with low autocorrelation.
This research opens up new possibilities for risk managers and institutional investors to optimise their portfolios. Since price patterns influence call and put options in the same direction, investors can better fine-tune their options strategies to achieve specific risks and goals. It’s highly useful for institutional investors who use options to hedge risks and to seek profits.
“The magnitude implies that the benefit of trading stock options based on stock return autocorrelation is considerable, especially for put options,” says Professor Li. “In addition, put options can be used for risk management, so taking stock return autocorrelation into consideration could enhance risk management performance as well.”
Weighing various factors when investing
The research adds to a growing body of work that explores what drives option returns, highlighting how patterns in stock prices play a crucial role. The findings show that the traditional Black-Scholes model assumption doesn’t always hold up. When stock returns show a high autocorrelation, it affects option returns in ways the model doesn’t predict.
Savvy investors should look beyond traditional pricing models and pay attention to how stock prices have moved historically. “The mechanisms of option pricing and option investment could be significantly different from each other,” Professor Li adds.
“While one of the crucial determinants is stock return autocorrelation, there could be other stock characteristics that do not affect option prices, but affect option returns, which practitioners could benefit from considering this difference.”
