The concept and use of financial options have existed for centuries. One of the earliest documented option trades is found in Aristotle’s fourth-century BC book, Politics, where he documents how Thales of Miletus profited from a plentiful olive harvest by using an options contract.

Simply put, an option is like a prepaid discounted voucher that gives the right to buy or sell the underlying asset at a fixed price, with a maturity date. This allows investors to make a profit if the price moves in their favor.

According to Aristotle, Thales predicted that his region would receive a bountiful olive harvest, that would mean a high demand for olive presses. Despite not owning olive presses, Thales set out to corner the market by paying olive press owners to secure first rights to use their presses (a call option) at harvest time (by paying the option premium). During harvest, it was indeed a plentiful crop and farmers had a hard time accessing olive presses because of Thales’ arrangement.  Thales then exercised his option and sold his rights to use the olive presses to those who needed it, making for himself a tidy profit.

Price analysis can provide valuable clues

Back to the present, options are a widely accepted derivative contract with a mixed reputation.  Lack of understanding and errant trades have led to options being perceived as a high-risk investment instrument. However, options trading is common enough among retail investors that CNBC and Investopedia have website pages dedicated to it.

In a study at the National University of Singapore (NUS) Business School, we analyzed the difference between the options-implied and traded prices of a stock. Option-implied prices refer to share prices derived from observed option prices, under assumptions that prevent arbitrage. We found that often times, there is a difference between option-implied prices and share prices, and this difference unveils valuable information about the stock value.

My fellow researchers and I studied a 17-year sample of prices and returns of stocks traded on the NYSE, NASDAQ, and AMEX and those derived from options data sourced from OptionsMetrics, a provider of options pricing information.

Four key findings emerged: 

1. Understand why option-implied and traded share prices differ

Often, there is a Difference between the Option-implied and Traded Share prices, or DOTS for short. Both are affected by the company’s fundamentals such as reported financials, business strategy, market conditions and expectations about future performance. They reflect investors’ view of a company’s value.

Share prices may be also influenced by extreme buy or sell trades, creating pressures that drive share prices temporarily away from fundamental values. But such trading demand shock does not necessarily propagate to the options market. Unlike stock trading, where there is a finite number of shares available, traders can easily create option contracts, thus implying a relatively higher elasticity of supply of options compared to stocks. Thus, trading induced stock price pressure generates high DOTS.  .

Another reason for high DOTS is that option market attracts more informed traders because of the leverage implicit in options. Consequently, the option-implied prices incorporate information faster than the stock market.

In either case, when option-implied price is higher than traded share price, or positive DOTS, share prices tend to trade upwards and align with the option-implied price. Conversely, when option-implied price is less than the share price, or negative DOTS, share prices are expected to decrease to align with option-implied price.  By understanding what caused the difference between the option implied price and share price, investors will be able to have greater clarity on the source and direction of traded share price.

2. Predictable stock returns disappear as fast as they appear

When large DOTS are observed, it predicts the direction of the share price movements. Specifically, stocks with large positive DOTS outperform stocks with large negative DOTS by about 80 basis points over the next day. Consistent with the notion that DOTS are related to temporary stock price pressure, the share price converges to option-implied prices within one or two days. 

3. Price pressure higher in small, illiquid stocks

Extreme DOTS readings are more commonly observed for small companies whose shares are thinly traded. The illiquid nature of these stocks is also reflected in the bid-ask spread, which is the difference between what buyers are willing to pay and what sellers are willing to receive. Hence, strong gains in trading stocks in extreme DOTS is accompanied by illiquidity, which makes trading costly for small investors.

What does this mean for investors?

When stocks have extreme returns, it could be due to new information or price pressure from heavy stock trading. For example, a large negative stock return could be due to bad corporate news or heavy selling for non-informational reasons like when a large investor sells the stock to meet heavy withdrawals from their investment fund.

If the large price decline is due to bad news, prices will not revert as they reflect the new information. If the decline is due to selling pressure, we expect DOTS to increase significantly, and prices to reverse subsequently when the pressure subsides.

Hence, by anchoring stock prices implied by options market, DOTS provides an important measure to identify temporary price pressure that some investors can potentially profit from.  It also helps investors to distinguish between fundamental changes in stock value from price changes due to market frictions. 

Today, trading equities is convenient and machines are programmed to optimize trading. However, the basic caveats remain relevant regardless of investment vehicle; investors should have a clear knowledge of how it works, understand the underlying assets and assess the best approach for their investment strategy.