Why does the Option to Stock Volume Ratio Predict Stock Returns?

Abstract

We use data on signed option volume to study which components of option volume predict stock returns and resolve the seemingly inconsistent results in the literature. We find no evidence that trades related to synthetic short positions in the underlying stocks contain more information than trades related to synthetic long positions. Purchases of calls that open new positions are the strongest predictor of returns, followed by call sales that close out existing purchased call positions. Overall our results indicate that the role of options in providing embedded leverage is the most important channel why option trading predicts stock returns.