Does Option Trading Convey Stock Price Information?

Abstract

After executing option orders, options market makers turn to the stock market to hedge away the underlying stock exposure. As a result, the stock exposure imbalance in option transactions translates into an imbalance in stock transactions. This paper decomposes the total stock order imbalance into an imbalance induced by option transactions and an imbalance independent of options. The analysis shows that the option-induced imbalance significantly predicts future stock returns in the cross section controlling for the past stock and options returns, but the imbalance independent of options has only a transitory price impact. Further investigation suggests that options order flow contains important information about the underlying stock value.