Myroslav Kostyuk 11/15/2011
Econ 204 – Networks Blog 2
Information Cascades in the Financial Markets.
Article: http://www.reuters.com/article/2011/04/25/silver-fund-options-idUSN2522530820110425
Readings from chapter 16 provide insight to the choices presented for participants in the derivatives market; specifically the options market. There are two types of options; call options and put options. A call option gives the buyer the ability to buy 100 shares of an asset from the option seller (writer) at a specified strike price before a specified expiration date. In return, the buyer of the option pays the seller a premium. A put buyer pays the seller a premium for the ability to sell 100 shares of the underlying asset before an expiration date for a specified strike price.
Traders and investors buy these contracts as an insurance tool to hedge their existing positions in the underlying asset, or a speculative vehicle to create leveraged position; controlling a large number of shares by risking only the premium paid. Below is a table of the available calls and puts for the popular silver commodity ETF (exchange traded fund) SLV. The expiration month is December of 2011, and the current price of SLV is 32.82
Refer to figure 1 (data from www.investools.com)
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- figure 1
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- Figure 2
For example, if a pension fund held 10,000 shares of SLV (long position) and the risk manager wanted to buy put options to protect their holdings against a sharp drop in the price, he would purchase 100 put options at strike price of 30.00 and would pay a $7,200 premium (0.72 x 100 x 100). The seller of these contracts, lets say a hedge fund, receives $7,100 and the dealers get to keep the bid/ask spread, which is $100 ((0.72-0.71) x 100 x 100). Until the third Friday of December (expiration date), the pension fund has the ability, not the obligation, to sell 10,000 shares of SLV to the hedge fund at the price of $30/share in case price of silver tanks. If price remains unchanged, hedge fund keeps the premium; earns a profit by taking risk, and the pension fund loses the premium, but had an insurance against an unwanted loss; loses cash-flow by avoiding risk.
The interesting part of this market, is that it serves as a potential indicator of investor sentiment. This is for two reasons; options market provides high potential leverage, and professional participants use this market for most of their speculative trading (non investment oriented) High trading volume on call option contracts can signify either a bullish sentiment in the underlying asset price as traders buy call options to establish speculative long positions, or a cautious brearish sentiment as traders buy call option contracts to hedge short positions. Same thing with put options; high put trading volume (above 30day-daily average) can signify a bearish sentiment as traders buy put contracts to establish speculative short positions, or a cautious bullish sentiment as traders buy put contracts to hedge long positions in the underlying asset.
These strong/weak volume days can serve to provide high/low signals based on the state, which is either bullish or bearish. Strong volume on call options is a high signal if investor sentiment (state) is bullish, or a false high signal if investor sentiment (state) is bearish. Strong volume on put options is a low signal if investor sentiment (state) is bearish or a false low signal if sentiment (state) is bullish.
Refer to Figure 2 – Table for H/L signals and their probabilities.
This is a very simple overview of the high/low signals and their respective probabilities. Depending on q, which should be greater than 0.50 (assuming high signals provide useful information), information cascades can form during consecutive trading days of a high trading volume (above 30day-daily average). This forms a complex interaction between hedgers and speculators as the price of these contracts rises and falls during the trading day. High option trading volume can also cause extra volume in the underlying asset (reverse causation), based on either true or false signals.
The best time to observe this is right before earnings announcement when the trading volume is high. Unusual results cause high volatility in the stock price of a particular company and the option prices are even more volatile as the unexpected result creates a cascade of information that causes heavy selling (or buying) pressure in the market. Assuming there is no arbitrage, options trading is a zero sum game on a nominal scale, where dollar per dollar the amounts exchanged sum up to zero as the contracts expire. However, the market provides an external benefit to the economy as it creates an insurance market where risk takers and risk hedges can exchange their risk for various combinations of cash flows.