Option Volume Imbalance Is a Predictor of Market Returns

Options volume has been shown to be a predictor of future market returns. By tracking the level of options volume, traders can get a sense of where the market is heading and make more informed investment decisions.

On a similar topic, Reference [1] examined the Option Volume Imbalance (OVI) and its relationship with the future prices of the underlying assets. The authors utilized data from the PHLX exchange to conduct research. They pointed out,

…we have defined the OVI feature and showed how it can act as a predictor for future equity returns. Focusing on the PHLX exchange, we compared OVI across MPCs, and found that the Market Maker’ OVI consistently provides the highest predictability, yielding annualized Sharpe Ratios of up to 4.5, for a simple betting scheme (without taking into account transaction costs). In terms of PnL, the tail portfolios corresponding to the strongest signals, can attain up to 4 bpts per day, depending on the sizing scheme employed. We have shown that some level of predictability is also present for Customer and Broker OVIs, while no predictability was concluded for Firm Proprietary trades and Professional Customers. We demonstrated how to improve performance, by taking into account the OVI’s magnitude. In particular, when using quantile rank groups, we found that the 2nd-4th quantile rank groups are typically the best performing.

In short, the authors showed that the Option Volume Imbalance has predictive power on directional overnight price movements for the underlyings. They also demonstrated that the Option Volume Imbalance from high implied volatility contracts is significantly more informative than options contracts with low implied volatility.

In closing, this paper contributes to the body of research that focuses on the predictive power of options volume. This research could open door to further studies that examine option volumes from different data sets, and at different time frames.

References

[1] Michael, Nikolas and Cucuringu, Mihai and Howison, Sam, Option volume imbalance as a predictor for equity returns (2022). https://arxiv.org/abs/2201.09319v1

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