Abstract
Prior research argues that pessimistic traders can use options as substitutes for short sales particularly when stocks are expensive to short. Motivated by this contention, we examine the relation between put-call ratios, short-selling activity, and constraints to short selling. Results show that (1) put-call ratios are inversely related, instead of directly related, to proxies for short-sale constraints and (2) the significant negative relation between current put-call ratios and future returns (Pan and Poteshman in Rev Financ Stud 19:871–908, 2006) is orthogonal to proxies for short-sale constraints. These results indicate that short-sale constraints do not influence bearish option activity. While prior studies show that short sellers are generally contrarian in contemporaneous and past returns, we find that put-call ratios follow periods of negative returns. However, any observed return predictability contained in put-call ratios is driven by ratios that follow periods of positive returns.
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Notes
Bodie et al. (2009) argue that during periods of down markets, investors are likely underhedged and therefore investors will attempt to purchase more put options to protect their long positions.
We note that not all option trading activity should be considered informative trading. Blau et al. (2014) show that the ratio of call option volume relative to put-option volume is directly related to characteristics of the underlying stock that resemble lotteries. These results suggest that some option activity might reflect investors’ preferences for lottery-like distributions. We follow Pan and Poteshman (2006) in order to isolate what might be considered informed option trading activity.
Bloomberg data contains volume for both call and put options across all strike prices and across all expirations.
We also examine the short ratio which is defined as the percentage of trading volume that is made up from short volume, which is commonly used in prior studies. Our results are qualitatively similar. In each of our regression specifications, we control for some form of trading activity so we prefer to result the short-turnover results for brevity.
We report CRSP raw returns in the paper. However, in unreported result we examine two types of market-adjusted returns. EW_adj_ret are CRSP raw returns less the equally weighted CRSP index return while VW_adj_ret are the CRSP raw returns less the value-weighted CRSP index return. The results using these alternative returns produce findings that are qualitatively similar to those reported in this paper.
An examination of hedging activity during bull and bear markets might be a fruitful area for future research. However, these tests are beyond the scope of this paper. See Bodie et al. (2009), p. 742, for example.
We also sort stocks by the other proxies of short-sale constraints and the results are generally similar with the exception of turnover sorts, which produce mixed results. The institutional ownership proxy is given a heavier weight based on arguments in D’Avolio (2002), Asquith et al. (2005), Nagel (2005), and Xu (2007).
Recent theory in Bakshi et al. (2010) suggesting that short selling can affect option prices. Here, we are examining both short selling and option activity on the prices of underlying securities instead of the prices on the options. While outside the scope of this study, perhaps a fruitful area for future research might be to examine the effect of short selling on option returns.
Similar results are obtained when using pooled OLS while controlling for conditional heteroskedasticity and clustering in the error terms.
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Blau, B.M., Brough, T.J. Are put-call ratios a substitute for short sales?. Rev Deriv Res 18, 51–73 (2015). https://doi.org/10.1007/s11147-014-9102-3
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DOI: https://doi.org/10.1007/s11147-014-9102-3