Does Options trading drive the price movement of the underlying or vice versa?
Options trading is used in three ways: Speculation, to generate income, or to hedge existing positions.
In the case of speculation, it is about taking a side and trying to profit from a move in the market. The market can only move in one of three directions, up (bullish), down (bearish, or sideways (neutral).
The way the prices of the underlying asset (stock or ETF for equities) moves impacts the price of the option derived from its value.
Individuals who trade in options are volatility traders at the core as volatility is the key factor in option pricing and in the profitability of the trade. A call buyer (holder) is bullish, but also bets that the volatility of the stock will be more than that priced into the call. A covered call writer (seller) bets that the volatility of the stock will be less than that implied by the option.
One measure of the way option activity that can greatly influence a stock’s price is the put/call ratio. You know that call buyers are bullish and put buyers have a bearish outlook. Take the number of puts purchased and divide that by the number of calls bought and you will come up with a number that is either more or less than one. This tells you that a higher put volume results in a ratio that is more than one, resulting in a bearish market outlook. Such an outlook most likely will impact market sentiment and drive bears over bulls. A ratio that is relatively low indicates a bullish outlook and drives the market up.
It is important to consider what happens when the strike price of the option is equal to or approximately close to the market price of the underlying stock or ETF at expiration. This is referred to as pin risk to the seller of the option, with the stock price pinned to the strike price. This happens due to early exercise at the closest strike price which inevitably increases volume around that price level.
The Problem With Pink Risk
It may become difficult for the seller to properly hedge their position, subjecting the seller to a potential loss (or gain) because an exercise may occur. As a seller, having an option expire out-the-money will not result in exercise, or a positive outcome.
Any perceived volatility that may occur in the few moments before expiration that results in an uptick in the price of the stock, making it go in-the-money, will result in an exercise, the size of the uptick could result in a diminished gain or huge loss for the seller.
Options overall stabilize stock prices. Despite this, these derivatives have received a bad reputation over the years. Likely due them incorrectly being tied to the housing crises (these were Credit Default Swaps – not options). Also there is the recent bombardment of fraudulent binary options schemes. Binary Options is a gambling ‘product’ which has nothing to do with standardized equity options contracts. Nevertheless, it is still dishonestly marketed as a legitimate investment product.
A study published in the Journal of Applied Financial Economics found that the issuance of stock options on securities issued in the Taiwanese market created positive abnormal returns. In addition to that, an increase in trading volumes and a decrease in the overall volatility of the market.
Options are intended to work the same way as future prices do with commodities. Futures contracts peg the future price of a commodity for a buyer or seller. This certainty removes the volatility of commodities prices prior to sale in a way similar to the way options behave. I believe that it is fair to conclude that trading in options influence stock prices. However, inherent volatility drives stock prices also influence and control the price of an option.
I am the co-founder of the startup 24/7 Automated Options Strategy Screener-Ranker Analyzer [Free]. Of course, we focus on standardized equity options technology and tools for investors.
We speak at length on dishonest marketing and options trading scams on both our about page as well as our blog. Would appreciate your thoughts and feedback there.