Review of Quantitative Finance and Accounting, 24: 159–176, 2005
2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.
The Informational Role of Option Trading Volume
in Equity Index Options Markets
Professor of Finance Department of Finance, Insurance and Real Estate, St. Cloud State University, St. Cloud,
MN 56301-4498, USA, Tel.: (320)308-3231; Fax: (320)308-5184
Abstract. This paper examines the dynamic relations between future price volatility of the S&P 500 index and
trading volume of S&P 500 options to explore the informational role of option volume in predicting the price
volatility. The future volatility of the index is approximated alternatively by implied volatility and by EGARCH
volatility. Using a simultaneous equation model to capture the volume-volatility relations, the paper ﬁnds that strong
contemporaneous feedbacks exist between the future price volatility and the trading volume of call and put options.
Previous option volumes have a strong predictive ability with respect to the future price volatility. Similarly, lagged
changes in volatility have a signiﬁcant predictive power for option volume.Although the volume-volatility relations
for individual volatility and volume terms are somewhat different under the two volatility measures, the results
on the predictive ability of volume (volatility) for volatility (volume) are broadly similar between the implied and
EGARCH volatilities. These ﬁndings support the hypothesis that both the information- and hedge-related trading
explain most of the trading volume of equity index options.
Keywords: option volume, future volatility
JEL Classiﬁcation: F23, F31
Several recent studies examine the informational role of the volume of option and stock
trades in predicting the future stock price movements (Llorence et al., 2002; Chan, Chung
and Fong, 2002; Easley, O’Hara and Srinivas, 1998; Hasbrouck, 1991). Black (1975) and
Mayhew, Sarin and Shastri (1995) argue that lower transaction costs and greater ﬁnancial
leverage of the options markets may induce informed traders to trade in the option market
rather than in the stock market. Further, Back (1993) and Cherian (1993) argue that investors
who possess private information about the future volatility of the stock price may be more
attracted to the option market instead of the stock market because they can only make their
bet on volatility in the option market.
Easley, O’Hara and Srinivas (1998) examine the lead-lag relations between the trading
volume of options on individual stocks and the prices of the underlying stocks, and show
that the option trading volume indeed contains information about the future stock prices.
However, Chan, Chung and Fong (2002) report that the option net trade volume has no
strong predictive ability for stock quote revisions. Similarly, many studies examine the links
between option prices and stock prices, option volume and stock volume, option prices
and stock volume, and stock prices and stock volume (Manaster and Randleman, 1982;