Correlation Between Open Interest and Derivative Strategies and Optimize These Strategies: Empirical Evidence from Nifty Option Market

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Later in the year 1978 Klemkosky (“The Impact of Option on Stock Prices”, Journal of Financial and Quantitative Analysis, Vol. 12, pp.507 – 518) uses the weekly returns data to analyse the effects of expiration of options contracts. He found the underlying stock gives negative return in the expiration week and gives a positive return in the week just after the expiration. His findings contradict the weak form of efficient market hypothesis wherein the average returns are predictable in the expiration and subsequent week.

Hayes and Tennenbaum in 1979 (Hayes, Samuel L. and Michael E. Tennenbaum, 1979, The impact of listed options on underlying shares, Financial Management, Winter, 72 – 76) studied the impact of listing an equity in the option market to the volume of the corresponding equity in the cash market. They found that listing of a stock in options market does increase the volume of trading of the underlying asset in the cash market. They concluded that this increase in volume is because of the variety of trading strategies in options market and also the interlink between the cash and the options market which incorporated continuous feedback of information from one market to other.

Officer and Trennepohl in 1981 (Officer, Dennis T. and Gary L. Trennepohl, 1981, Price behaviour of corporate equities near option expiration dates, Financial Management, 10, Summer, 75 - 80) used the findings of Klemkosky to analyse the price behaviour of the underlying equity asset around its expiration date and found that price of the stock which is also trade in option market may experience downward pressure two days before the expiration day in options market. This abnormal price behaviour is very low if we consider taxes, transaction and other costs. They also found that unexplained volatility in price near the expiration period is slightly greater than the predicted volatility in price.

Manaster and Rendleman in 1982 (Manaster, Steven and Richard J. Rendleman, 1982, Option prices as predictors of equilibrium stock prices, Journal of Finance, 37, 1043 - 1057) document the evidence in support of option market leading the stock market. They contend that an option trader is likely to be more informed than the average stock investor, and option prices may reflect additional information which is not captured by the underlying stock prices in cash. The closing prices of listed call options contain information about the equilibrium stock prices that is not contained in the closing prices of underlying stocks.

Bhattacharya 1987 (Bhattacharya, Mihir, 1987, Price changes of related securities: The case of call options and stocks, Journal of Financial and Quantitative Analysis, 22, 1-15.) contends that option prices do contain some information not already contained in contemporaneous stock prices. However, they acknowledge the insufficiency of such information to overcome bid-ask spread and search costs.

Conrad (1989, Conrad, Jennifer, 1989, The price effect of option introduction, Journal of Finance, 44, 487-498) investigates the effect of option introduction from 1974 to 1980 and concludes that it has positive permanent price effect on the underlying security beginning slightly before the introduction date. She suggested that timing of price effect just before the introduction of options (not announcement) may be due to the traders building inventory for hedging purposes in anticipation of trading volumes in options. She also concludes that the variance of average excess return has also declined after the introduction of options while the systematic risk has remained the same.

Skinner (1989, Skinner, Douglas J., 1989, Options markets and stock return volatility, Journal of Financial Economics, 23, 61 - 78) concludes that option listing is associated with a decline in stock return variance and an increase in trading activity in underlying stock but didn’t find any impact on non-diversifiable risk (beta) of the stock. However, he was unable to find the evidence whether the decline in variance of observed returns is attributable to the changes in trading noise.

Extending the conclusions of his earlier study, Vijh (1990, Vijh, Anand M., 1990, Liquidity of the CBOE equity options, Journal of Finance, 45, 1157-1179) did not find the evidence to suggest that large option trades are motivated by superior information about the future stock prices. Rather, he contends that what seems to be superior information may just be the difference of opinion. He finds no evidence of temporary or permanent price effect surrounding large option trades on CBOE.

Detemple and Jorion (1990, Detemple, Jerome and Philippe Jorion, 1990, Option listing and stock returns - An empirical analysis, Journal of Banking and Finance, 14, 781-801) contend that an option written on a stock cannot be replicated by a trading strategy in the stock and bonds as it expands the opportunity set of investors by enabling them to achieve payoff patterns that could not be achieved in its absence. They note that the introduction of option market increases the speed at which information is released to the market because investors with private information prefer to take position in option market as against the stock market. Therefore, the introduction of options has price effects, volatility effects, cross effects, announcement effects and persistence effects on the market for underlying shares. For the first time, they investigated the impact of delisting of options and found it to be just reverse of the listing effect.

Rejecting the claims of earlier studies, Stephan and Whaley (1990, Stephan, Jens A. and Robert E. Whaley, 1990, Intraday price changes and trading volume relationships in the stock and stock options markets, Journal of Finance, 45, 191-220) conclude that price changes in the stock market leads price changes in the option market for CBOE call options traded during the first quarter of 1986 by about fifteen to twenty minutes on an average. To supplement the findings of price changes relationship between stock market and option market, they investigate the trading in both these market and conclude that trading activity in stock market leads the one in option market by even longer period of time, i.e. five to ten minutes longer than in price change results.

Damodaran and Lim (1991, Damodaran, Aswath and Joseph Lim, 1991, The effects of option listing on the underlying stocks' return processes, Journal of Banking and Finance, 15, 647-664) document the potential explanation for the observed variance decline after listing of option contracts. They conclude that option listing does not lead to shift in intrinsic variance rather it expedites the price adjustment process. It also leads to decline in the noise term that can be attributed