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Stoyu I. Ivanov University of Nebraska - Lincoln Department of Finance Lincoln, NE 68588-0490 Phone: (402) 472-3445 Email: ivanovsi@bigred.unl.edu

Yi Zhang* Prairie View A&M University Department of Accounting, Finance and MIS Prairie View, TX 77446 Phone: (936) 261-9225 Email: yizhang@pvamu.edu

EXCHANGE TRADED FUNDS AND INDEX ANALYSIS: VOLATILITY AND OPTIONS

Abstract Exchange Traded Funds (ETFs) track their underlying index closely and are relatively inexpensive instruments for risk diversification. We examine the volatility of the three most liquid ETFs (DIA, SPY and QQQQ) and their tracking indexes (DOW, S&P 500 and NASDAQ 100). We find no significant difference in the realized return volatility between ETFs and indexes even controlling for nonsynchronous trading. However, as the best predictor of volatility, the option-implied volatility of ETFs is significantly different from that of indexes. We further examine the implied volatility function of stock options and index options using unique pair samples of ETFs and their tracking indexes. We find that the differential implied volatility function is related to open interest. Our results are consistent with the net buying pressure theory proposed by Bollen and Whaley (2002), and inconsistent with the argument of Bakshi, Kapadia and Madan (2003) which attributes the difference to differential return distributions. Our study also explores whether ETF options are used more for speculation or hedging, and whether they are a viable, stand alone new investment opportunity or they are just an alternatives to index options.

1

ETFs keep on trading after hours until 4:15pm while indexes are reported at 4:00pm. The proportions and exact composition of the ETF portfolio might differ from that of the underlying index since minimization of costs might result in difference in the composition of ETF portfolio and index. We attempt to fill this void by studying the volatility of ETFs relative to their underlying indexes.55 billion in 2006. We focus on the higher moments of return – volatility. The ETF manager closely tracks the yield and price of the underlying index by holding either the contents of the index or a representative sample of the securities in the index. These differences may cause a deviation of the return of an ETF from the return of its underlying index. an increase of 544% for the period. The ETF assets also increased significantly in that period from $65. Our sample includes the three most liquid 2 .59 billion in 2000 to $422. most literature on ETFs focuses on their tracking errors and very little research has been conducted in the area of variability of ETFs which has a greater importance for risk diversification.1. ETFs are passive investment vehicles. Additionally. However. In this study we examine not only the mean deviation of the return of an ETF from the return of its underlying index. skewness and kurtosis. ETFs accumulate dividends in a non-interest bearing account and distribute accumulated dividends in a lump sum periodically. but the whole return distribution. ICI reports that there were 80 ETFs in 2000 and 359 ETFs in 2006. Also. They have become an important investment vehicle to both professional and individual investors as evident from the Investment Company Institutes’ (ICI) statistics. a 350% increase. Introduction Exchange Traded Funds (ETFs) appear to be a relatively cheap instrument for diversification in terms of direct costs.

VIX (a measure of the implied volatility of S&P 500 index options) is widely used to estimate the market volatility. Using realized daily returns over more than six-year period. and Madan (2003) attribute the differential implied volatility function of stock options and index options to the differential return distributions of the underliers. we find insignificant difference in the return distributions of ETFs and indexes. For example. while the implied volatility level of DIA is lower than that of Dow Jones Industrial Average. using ETF options and index options produces a unique sample to explore the implied volatility of stock options versus index options. S&P 500 and NASDAQ 100 respectively. These ETFs are tracking the yield and price of the Dow Jones Industrial Average. Since ETFs track their underlying index closely and are not significantly different from their underlying index in the return distribution. Previous studies suggest that the implied volatility of an option is a good predictor of the underlying asset’s future volatility. We thus examine the implied volatility of ETF options and their corresponding index options. The implied volatility level of SPY and QQQQ is higher than that of S&P 500 and NASDAQ 100 respectively. We find that the implied volatility level (the implied volatility of at-the-money options) of ETF options is significantly different from that of index options. Kapadia. ETFs are traded like stocks so ETF options are stock options. SPY and QQQQ. We also find that the shape of the implied volatility function (volatility smile/skew) is different between ETF options and index options. and is related to open interest.and well-known ETFs: DIA. Bakshi. An alternative way to approach risk is by using the options’ implied volatility. Our results are consistent with the argument of Bollen and Whaley (2004) that the implied volatility function is related to the net buying pressure of options. 3 .

the difference in implied volatility functions between ETFs and indexes can be attributed to other factors than return distribution difference. we attempt to explore the use of ETFs for hedging or speculation. The paper contributes to the literature in the following ways. which plays an important role in risk diversification. First. Put options are widely used for downside protection. the paper fills the void of volatility in the literature of ETFs. Third. The advantage of using pair samples of ETF options and index options is that return distributions of ETFs are insignificantly different from their tracking indexes.Net buying pressure is related to investor speculative or hedging demand for options. Therefore. the speculative motive for trading ETFs cannot be ruled out. We examine both the realized return volatility and the option implied volatility – a valid predictor of future volatility. 1985) at the same time Moran (2003) suggests that ETFs are used widely for hedging purposes of long term risk exposures of highly concentrated portfolios. Theoretically. Therefore. Call options provide upside potential and thus out-of-the-money calls are more likely used for speculation. we attempt to find whether ETFs are more often used for speculative or hedging purposes. we perform univariate and multivariate tests on the open interest and put/call ratio of ETF options and index options to find whether ETF options are just alternatives to index options or they produce new investment opportunity. Therefore. Index options are widely used for hedging purposes (Evnine and Rudd. It is interesting to know whether ETF 4 . Second. the paper adopts a unique sample to reexamine the net buying pressure theory of Bollen and Whaley (2004). Especially out-of-the-money puts are low-cost instruments for hedging. examining the option’s open interest provides insight on the use of options. such as net buying pressure. However.

most literature on ETFs focuses on their tracking error (for example. We study the volatility of ETFs with respect to their underlying indexes. Also ETFs lack 5 . The paper is organized as follows: Section 2 examines the related literature and develops the research scope of the paper. For example SPY and QQQQ distribute dividends quarterly and DIA pays dividends monthly. there should not be much difference in the variability of the ETF and the index. 2. Nevertheless. Section 3 describes the data and empirical methodology. However. small-firm and common closed-end family of funds risks. Closed-end funds are similar to ETFs in that both are traded on a stock exchange throughout the trading day. 2002.options provide new investment opportunities or they are just an alternative to index options. Poterba and Shoven. but ETFs are structured differently from closed-end funds. and Engle and Sarkar. Section 4 presents empirical results and Section 5 concludes. 2006). Since ETFs are passive portfolios tracking an index. ETFs are legally structured to resemble open end funds in the sense that new ETF securities can be issued. Pontiff finds that closed-end funds are more volatile than the underlying securities. The excess risk in closed-end funds is predominantly idiosyncratic risk and to a smaller extent due to market. To our knowledge there are no studies focused on the volatility of ETFs. Literature Review and Research Development ETFs are exploding in popularity. ETFs accumulate dividends and then distribute accumulated dividends in a lump sum periodically. For example. Pontiff (1997) conducts a study of the excess volatility characteristics of closed-end funds.

Hence. Considering the nonsynchronous ETF prices and index levels at closes. In addition. Since past realized volatility of ETFs are insignificantly different from that of indexes. Therefore. These characteristics of ETFs might suggest difference in the volatility of ETFs and their underlying indexes. We thus investigate the implied volatility of ETF options and index options. However. Kapadia. Existing literature on the implied volatility shows that the implied volatility function of stock options is different from that of index options. ETFs keep on trading after hours until 4:15pm when their underlying indexes are reported at 4:00pm. we empirically compare the variance. the implied volatility is not expected to be different. skewness and kurtosis of ETFs and their underlying indexes using realized daily returns. we have unique pair samples which are free from differential return distributions to examine the implied volatility 6 . we first test whether ETF options’ and underlying indexes options’ implied volatility functions differ due to the differential return distributions of ETFs and indexes. If this is the case. which will make their return distribution similar to indexes. we also use synchronized price data. ETFs are traded like stocks so that ETF options are considered stock options. ETFs closely track the performance of their underlying indexes. as well. and Madan (2003) study the S&P 100 options and the 30 largest stocks in the index and find index volatility smile (the variation of the implied volatility across strike prices) are more negatively sloped than individual stock volatility smiles. The option implied volatility is shown to do a better job in predicting future volatility than past realized volatility by Christensen and Prabhala (1998) and others. Bakshi. They show that this difference comes from the more skewed return distribution of individual stocks.short-sale constraints.

the open interest of options with various categories of moneyness. It would be interesting to know the major use of ETF options and we are the first to explore this question. Lakonishok et al. 7 . Despite the similarity in the volatility characteristics of indexes and ETFs. Additionally. there might be a difference in the implied volatility function between index options and ETF options. can be attributed to other factors than return distributions. we examine. When arbitrage is limited. (2004) find that the least sophisticated investors were using equity options for speculation during the Bubble period and the sophisticated investors were speculating moderately at this time.e. Options are low cost instruments for hedging or speculation. Bollen and Whaley study both index options and stock options and find that changes in the implied volatility of S&P 500 options are most strongly affected by buying pressure for index puts while changes in implied volatility of stock options are dominated by call option demand. Are they mostly used for hedging or speculation? Are they just alternatives to index options or new investment instruments for investors? To answer these questions. i. consistent with the existing finance literature. such as net buying pressure proposed by Bollen and Whaley (2004). This difference. depending on the option type or moneyness (away-from the money options or at-the-money options). Bollen and Whaley argue that option prices and implied volatilities are affected by the demand for options. the option supply curve is upward sloping so that the shape of the implied volatility function is related to the net buying pressure from public order flows. speculative or hedging purposes. Buraschi and Jackwerth (2001) show that options are used for different purposes. if exists.function of stock options versus index options.

and the data of the NASDAQ100 index from http://dynamic. Index options expire on the Saturday following the third Friday of the contract month and are cash-settled at the special quotation. the Diamonds (DIA). QQQQ from 03/10/1999 until 12/30/2005.com. All of these options are European options. We obtain the data of the Dow Jones Industrial Average (DJIA) from http://djindexes. 8 . the S&P500 index options (SPX) and the NASDAQ 100 index options (NDX).com. We use options data from the Chicago Board Options Exchange (CBOE) from 2003 to 2006 provided by deltaneutral. The options data are filtered based on the criteria suggested by Day and Lewis (1988). When closing prices are used. and for the QQQQ are from 03/10/1999 to 12/30/2005. The stock market closes at 4:00pm and the indexes are reported at 4:00pm. SPY & QQQQ) and the S&P500 index are obtained from the Center for Research in Security Prices (CRSP). and the Cubes (QQQQ after 12/01/2004 and QQQ before 12/01/2004)1. to align the trading periods prices are synchronized by obtaining last trading price of the ETF at market close at 4:00pm from NYSE TAQ database. we examine DIA and SPY from 10/01/1998 until 12/30/2005. We use the Dow Jones index options (DJX). Thus. but ETFs and options close trading at 4:15pm. When prices are synchronized.com. ETF options are American options. and Xu and Taylor (1994). Data and Methodology We study three ETFs: the Spider (SPY). the study periods for DIA and SPY are from 01/04/1999 to 12/29/2006.nasdaq.3. 1 The change in symbol was due to the migration of trading of Cubes from AMEX to NASDAQ. Data for the ETFs (DIA. The options used to form the sample are required to meet the following criteria: a) expiration greater than 7 days and less than 30 days from the trading date.

625 -0.875<∆p<= -0.875<∆c<=0. ETF options are American options while index options are European options.625<∆p<= -0.875 To investigate the potential differences in the implied volatility function of index options versus stock options.02 and 0.625<∆c<=0. ETFs and indexes have different return distributions as argued by Bakshi. and would not exhibit riskless arbitrage opportunities which will endanger the soundness of the conclusions. 9 . c) the boundary conditions of ETF options should follow American option boundary conditions: C < S − X and P < X − S . 2. These criteria were used so that options would not exhibit thin trading and extreme volatility.375<∆p<= -0.125 0.98.98 and hedging delta for put option is between -0.375 -0.625 0.02 and 0.375<∆c<=0.02<∆c<=0.125<∆p<= -0. and Madan (2003).98 -0.b) the boundary conditions of index options should follow European option boundary conditions: c < Se −Rf T − Xe − Rd T and p < Xe − Rd T − Se −Rf T .375 0.98<∆p<= -0. d) should not be far out or in the money so that: hedging delta for call option is between 0.125<∆c<=0. For the classification of moneyness we utilize the Bollen and Whaley (2004) categories based on options’ delta: Category 1 2 3 4 5 Labels Deep-in-the-money (DITM) call Deep-out-of-the-money (DOTM) put In-the-money (ITM) call Out-of-the-money (OTM) put At-the-money (ATM) call At-the-money (ATM) put Out-of-the-money (OTM) call In-the-money (ITM) put Deep-out-of-the-money (DOTM) call Deep-in-the-money (DITM) put Range 0. Kapadia. we consider several possible explanations: 1.125 -0.875 -0.02 0.

4. Note that we compute five day We have no data about returns for the synchronized closing prices. Transaction costs. Table 1 shows summary statistics using closing prices. since all used returns use closing prices. The multivariate model that we employ in the analysis is: Implied Volatility = β0 + β1 (open interest) + β2 (option volume) + β3 (bid-ask spread) + β4 (time to maturity) + β5 (index or ETF option dummy) + β6 (call or put option dummy) + β7 (OTM option dummy) + ε (1) 4. The demand for options. Results are shown in Table 2. proxied by the open interest. we also use synchronized prices and index levels2. 2 10 . The standard deviations of ETFs and their tracking indexes are not significantly different as evident from the performed t-tests. 1991). Thus we perform univariate and multivariate tests on the implied volatility function. The kurtosis and skewness are similar as well. Synchronization is performed by obtaining data from NYSE TAQ database. Empirical Results We start by examining historical realized daily returns of ETFs and indexes. We keep the last trading price within one second of 4:00pm to create the synchronized dataset. which suggests no significant difference in the distributions of ETFs and indexes. the bid-ask spread is larger for index options compared to ETF options. The average price level and return of ETFs and indexes are very close. is different for ETF options and index options. which provides intraday data for traded assets. Considering non-synchronous ETF prices and index levels at close (Harvey and Whaley.3.

0745 1715 1.8984 117.1665 0.0434 1715 1.8142 1.4415 16.1639 6.0275 1714 0.0132 8. dev.0006 0.5375 PRICE 57.0005 0.0095 PRICE 117.0004 0.0003 0.0932 -0.9312 1.8694 3. Data for DIA and SPY are from 10/01/1998 until 12/30/2005.0001 0.7295 1824 -0. count t-test skewness kurtosis QQQQ mean median st.0270 1714 -3.3142 retNDX -0.0117 1820 0.7600 78.rolling standard deviations for the synchronized data. and for QQQQ from 03/10/1999 until 12/30/2005.1691 6.0335 -3.0007 0.1470 82 11 .3356 103.3805 41.1588 st dev INDEX 2.7397 1.0734 87 retDIA 0.9129 0.1888 1.0114 1799 0.1678 87 0.6783 st dev ETF 2. count t-test skewness kurtosis PRICE 100. dev.1624 st dev ETF 1.0003 st dev INDEX 2.0001 0.0732 87 0.2398 38. The results in Table 2 are similar to the results in Table 1 in that there is insignificant difference in variance.7738 1821 -0.0002 0.6074 1.1462 priceindx 100. dev.2354 103.7876 1824 -0.0030 priceindx 117. and kurtosis between ETFs and indices.5477 priceindx 57. which indicates similarity in the distributions of prices of ETFs and indexes.0969 -0. DIA mean median st.0115 2011 0.0113 2011 0. in contrast to monthly standard deviations listed in Table 1.7990 1.7400 1.0247 38 41.8672 3. The standard deviation is computed monthly.5955 117.0640 3.6752 retDJIA 0.1200 retSPY 0.1755 87 st dev ETF 2.9104 0. return and volatility of ETFs and Indexes.1606 1.0002 0.6212 76. Table 1 Summary Statistics for ETFs and Indexes This table shows the closing price.8744 1.1716 2.2398 retQQQQ -0.0844 3.0324 sprtrn 0.0009 0.5359 1.0001 0. skewness.1832 2.7456 1821 -0.0936 st dev INDEX 1. count t-test skewness kurtosis SPY mean median st.1515 82 0.6200 16.3621 0.0002 0.1000 8.

Table 3 presents the mean and median of the implied volatility of each moneyness category.5130 9. for the SPY 01/04/1999 to 12/29/2006.3241 -0.5700 9. These differential implied volatility levels prompt us to investigate the shape of the implied volatility function.4281 1. dev.1584 priceindx 102.4518 120.6150 2.9473 0.8620 st dev ETF 1. and for the QQQQ 03/10/1999 to 12/30/2005.6884 1989 0.8693 3. we find that the at-the-money implied volatility is significantly lower for SPY and QQQQ than for their tracking indexes – S&P 500 and NASDAQ 100.9342 0.0431 st dev ETF 1. DIA mean median st.7291 120. count t-test skewness kurtosis SPY mean median st.5202 Since no significant difference in the return (or price) distribution of ETFs and indexes is detected we proceed by examining the implied volatility level of ETFs and indexes.2394 1988 -0.7701 0.7648 0.9712 275.9600 41.7034 0.8956 0.1754 st dev ETF 0.8906 1692 14.3214 -0. for the DIA 01/04/1999 to 12/29/2006.7150 4.Table 2 Summary Statistics Using Synchronized Prices This table shows the synchronized prices and volatility of ETFs and Indexes (five day rolling standard deviations in columns).3059 0.0981 0.6951 0.9558 6.9756 275.1371 14. dev.8951 0.5481 1984 1.3509 st dev INDEX 1. Date ranges of data are as follows.8818 1692 -0.6278 2.4662 PRICE 119.4905 priceindx 57.0128 37.0252 1699 1.2809 1988 -0. count t-test skewness kurtosis PRICE 102.4500 104. count t-test skewness kurtosis QQQQ mean median st. First.5178 1993 -0. dev.7059 4. while the at-the-money implied volatility is significantly higher for DIA compared to DJX.9032 6.5818 1993 -0.7100 16.3623 40.4543 priceindx 119.6903 st dev INDEX 0.4290 16.5515 1984 0.3195 0.9933 1699 1.8672 3.3786 104. 12 .8252 st dev INDEX 1.6809 1989 1.1074 0.0296 1.4753 PRICE 57.2302 38.

3225 0.1368 0.2157 0.1163 0.1526 0. Since the underlying indexes’ and ETFs’ return distributions are similar we then examine whether the implied volatility function is related to other factors. The first type of put-call ratio is the sum of open interest of 13 . For deep out-of-money puts (or in-the-money calls).1344 0.1460 Median 0.3082 0.1287 0.2018 0.1461 0.1451 Median 0.1791 0.1186 0. Out-of-the-money puts are cheap instruments for hedging while out-of-the-money calls are very attractive for speculation.1530 0.1727 0.2346 Median 0.2192 0.1565 0.2233 0.Table 3 Implied Volatility (Restricted Expiration between 7 and 30 days) Category 1 2 3 4 5 Category 1 2 3 4 5 Category 1 2 3 4 5 N 412 412 412 412 412 N 436 441 392 431 430 N 1253 1254 1253 1250 1230 SPY Mean 0.1624 0. ETF options have consistently higher implied volatilities than index options.2404 0.1594 0.2404 QQQQ Mean 0.1816 Figure 1 presents the volatility smiles for the pairs of ETFs and indexes.1440 0.1281 0.2375 0. Table 5 reports two calculations of put-call ratios used to examine the use of options.1342 0. For deep out-of-the-money calls (or in-the-money puts).3081 0.1273 0.1256 0.2245 0.2763 0.1538 0.3459 Median 0.2780 0.1945 N 1237 1234 1234 1232 1203 N 1227 1245 1236 1247 1207 N 1216 1248 1241 1248 1210 SPX Mean 0.1680 0.2129 0.1870 NDX Mean 0.1349 0.1987 0. e. SPY and QQQQ have lower implied volatilities than their tracking indexes.1462 0.2030 0.1921 0.1476 0.1507 0.1589 0.2189 0.1370 0.3745 DIA Mean 0. Table 4 presents mean and median open interest for each moneyness category.2565 DJX Mean 0.g.1546 0. the demand for options. DJX and DIA exhibit similar smile patterns but DIA has a slightly more pronounced smile pattern than the DJX.1898 0.1984 Median 0.1105 0.2030 Median 0.1760 0.1607 0.

Also it seems that when examined alone. we find the implied volatility increases as options gets closer to expiration. We further conduct regression analysis to examine the relationship between the implied volatility and open interest. Alternatively. SPY and DIA options have larger put-call ratios than their tracking indexes (the opposite is true for QQQQ) which suggests that SPY and DIA options are even more widely used for hedging than index options.puts for the five categories of moneyness divided by the sum of open interest for calls of the five categories of moneyness. investors use more NDX than QQQQ for hedging. bid-ask spread and time to expiration. For ETFs. The negative relation between bid-ask spread and the implied volatility supports the arguments that the volatility smile is related to transaction costs. this also suggests that SPY and DIA are more often used for hedging while QQQQ is more often used for speculation. 3 Results for other categories will be provided at request. results presented in Panel A show that the implied volatility of deep-out-of-the-money puts are higher for DIA and SPY options than index options. Also consistent with previous empirical evidence. The significant relation between open interest and the implied volatility is consistent with the net buying pressure theory. These results suggest that DIA and SPY are again more often sought for hedging by investors than index options. Regression results are shown in Table 6. 14 . The implied volatility is negatively related to open interest. The second put-call ratio is computed by only using out-of-the-money and deep out-of-the-money options. For category 1 options. consistent with facts that more investors use index put options to hedge against market downturns. Only results for option categories 1 and 5 are presented3. while the opposite is true for QQQQ. Table 5 shows that there is consistently more open interest in puts for all underliers.

2500 0.3500 0.3000 0.Fig.3000 0.1000 0.0000 1 2 3 M one yne s s 4 5 SP Y SP X 0.0000 1 2 3 M one yne s s 4 5 QQQQ N X D 0.2000 0. 1 The Implied Volatility Smile For Spiders. Light Pink Color Index) 0.4000 0.3500 0.3000 0.2500 I V 0.0500 0.1500 0. Diamonds and Cubes’ Options and Their Respective Index Options.1000 0.1000 0.2500 I V 0. Restricted Expiration between 7 and 30 days (Dark Blue Color ETF.1500 0.0500 0.2000 0.1500 0.2000 I V 0.0000 1 2 3 M one yne s s 4 5 DJX DI A 15 .0500 0.

00 16 .00 Median 451067.36 QQQQ Mean 133624.03 184525.00 96029.90 111783.50 36062.00 18374.00 12317.70 13756.34 NDX Mean 50811.91 49754.15 142278.42 12085.00 40525.00 19320.91 18262.50 62641.00 16644.00 Median 6859.31 4271.50 3195.00 8966.23 14007.33 16829.84 28248.33 78426.00 136494.00 23792.00 4459.34 17689.95 SPX Mean 39763.75 12207.50 149754.97 51359.00 28024.00 3459.87 3137.00 Median 82498.24 NDX Mean 3113.82 QQQQ Mean 473633.05 184566.00 43067.00 Median 6622.00 13914.Table 4 Open Interest Panel A.75 17450.00 4298.72 8256.50 Median 34816.00 14863.50 119466.00 54387.08 DIA Mean 11234.50 17475.00 40346.50 17052.68 17479.50 46606.00 9728. Open Interest of Call Options Category 1 2 3 4 5 Category 1 2 3 4 5 Category 1 2 3 4 5 N 206 206 206 206 206 N 211 217 198 217 225 N 626 627 626 624 627 Median 27701.00 16895.01 32457.43 1198.50 15749.52 54059.00 Median 1007.58 Median 192385.27 4880. Open Interest of Put Options Category 1 2 3 4 5 Category 1 2 3 4 5 Category 1 2 3 4 5 N 206 206 206 206 206 N 225 224 194 214 205 N 627 627 627 626 603 SPY Mean 127157.75 217121.00 48639.00 147526.00 N 617 617 617 616 607 N 601 620 615 625 625 N 590 622 618 624 625 Median 16972.71 328046.36 2940.00 5724.00 271.00 14813.00 2731.19 SPY Mean 37902.40 158950.00 128287.95 12853.50 8104.50 965.43 DJX Mean 33724.05 60530.83 52144.00 50788.69 19922.00 1615.00 8628.87 16737.52 62866.66 4585.00 28230.00 14881.30 DJX Mean 13327.55 16815.91 DIA Mean 31547.00 297843.76 Median 101410.03 21633.25 141441.94 55856.21 45556.50 63140.00 38969.96 3946.00 Median 24513.21 54510.00 904.56 29936.00 Median 26546.33 76408.74 147289.00 171455.00 216742.09 52502.00 Panel B.00 N 620 617 617 616 596 N 626 625 621 622 582 N 626 626 623 624 585 SPX Mean 232237.41 20203.

4515 DJX 1.1720 DIA 1.6914 2. it might be because of the high technology nature of the underlying index which makes it more volatile and useful to speculators. while QQQQ options are more often used for speculation relative to the underlying index NDX option. QQQQ and DIA have higher implied volatilities than their tracking indexes.0286 1. our data indicates that DIA and SPY options appear to be more often used for hedging relative to their underlying indexes options. 17 .8725 2. Alternatively. suggesting that demand for speculation that market will move upward are higher for QQQQ and DIA options compared to index options.4701 NDX 1.Table 5 Put-Call Open Interest Ratio =sum open interest puts/sum open interest calls =sum 1 and 2 (OTM) puts/ sum 4 and 5 (OTM) calls =sum open interest puts/sum open interest calls =sum 1 and 2 (OTM) puts/ sum 4 and 5 (OTM) calls =sum open interest puts/sum open interest calls =sum 1 and 2 (OTM) puts/ sum 4 and 5 (OTM) calls SPY 1.7426 QQQQ 1.5097 2.5445 Table 6 Panel B presents results for deep out-of-the-money calls. But the SPY options are less demanded for speculation relative to SPX options.1928 1. The reason that we observe such a consistent inverse behavior of the QQQQ might be due to the more active market in the use of QQQQ options relative to the index options. Overall. as suggested by Moran (2003).8246 SPX 1.5144 2.

1317 0.8477 <.0001 -3.0665 estimate p-value 0. DITM put call variable Intercept opint bidask expirationtime dummyIndex interact put Intercept opint bidask expirationtime dummyIndex interact SPY and SPX Adj R-Sq 0. DITM is deep-in-the-money.0001 Adj R-Sq 0.0001 -0.8177 <.0001 9.0085 <.0001 Adj R-Sq 0. and DOTM is deep-out-of-the-money.3661 estimate p-value 0.0001 -5.0001 0.0001 -0.0083 0.6176 4.6979 <.0001 Adj R-Sq 0.0577 <.6584 <.0001 -0.2079 <.7845 <.0001 -0. DOTM put call variable Intercept opint bidask expirationtime dummyIndex interact put Intercept opint bidask expirationtime dummyIndex interact SPY and SPX Adj R-Sq 0.301 <.0001 0.0002 -42.013 <.0168 <.Table 6 Regression Results on the Implied Volatility The time period is from January 2003 to December 2006.0009 <.0095 <.0745 <.0001 -0.2797 <.8246 <.0001 4.0001 -0.0303 0.0641 <. bidask is ask price minus bid price divided by ask price.0001 -0.0704 1.03 <.0489 <.0001 3.7674 <.0606 0. expirationtime is expiration date minus current date.2659 <.3398 0.0001 -0.0001 -0.7604 <.0001 1.0001 0.0001 -0.9116 <. Panel A: Category 1.0001 -0.084 <.0001 -2. DOTM call.0034 5. DITM call.609 <.0488 <.2636 <.0001 -3.443 <.5815 <.4016 0.0179 <.1577 <.0015 0.0001 -0.0246 <.0001 0.0001 -1. interact is opint multiplied by dummyIndex.032 <.0001 -0.0001 -0.6094 <.2176 <. Opint is open interest divided by 1.0001 0.0001 0.0001 -8.0001 -0.2411 0.4504 0.000.0001 -0.000.0076 <.0023 <.756 <.3455 <.6543 <.4432 estimate p-value 0.0001 -0.0001 DIA and DJX Adj R-Sq 0.2789 estimate p-value 1.0001 -2.7463 QQQQ and NDX Adj R-Sq 0.0001 -4.0001 -0.0593 0.0001 DIA and DJX Adj R-Sq 0.0436 <.9551 <.0279 <.0001 -0.0017 <.1456 <.0001 -0.0001 -8.6315 <.0001 Panel B: Category 5.0001 Adj R-Sq 0.0157 <.2176 <.012 <.1677 <.0001 -10.0001 Adj R-Sq 0.4945 Adj R-Sq 0.0138 <.0001 QQQQ and NDX Adj R-Sq 0.0978 estimate p-value 0.623 <.0001 0.0001 -3.0001 -6.0001 -5.0102 <.0001 -4.0001 -0.0001 -0.0236 <.002 0.5842 0. dummyIndex is (1) for the index option and (0) for the ETF option.8009 <.0072 <.0016 <.0001 -0.0017 <.2036 <.0001 0.0001 -0.0001 -0.0001 -8.0983 <.3354 <.0001 -0.0134 <.5469 <.0001 18 .0052 <.0001 -43.0001 -6.0001 -0.0117 <.4672 estimate p-value 0.8895 <.

while QQQQ options are more often used for speculation relative to their underlying index options. Conclusion In this paper we study a popular investment vehicle that has achieved prominence. which has a significant meaning for risk diversification.the Exchange Traded Funds. 19 . These differences are related to transaction costs and open interest. The options on ETFs are a recent development and as such have not been extensively studied. We examine the volatility of ETFs relative to their tracking indexes. We also investigate whether ETF options are just an alternative to index options or they produce new investment opportunity. Because the option implied volatility is shown to be a better predictor of future volatility than past return volatility. ETF options expand investment opportunities and are not just mere alternative to index options. Therefore. we examine the implied volatility level of ETF options and index options.5. the latter relationship is consistent with the net buying pressure argument of Bollen and Whaley (2002). We document differential implied volatility levels and functions between ETF and index. We study realized return distribution characteristics of ETFs and indexes and find no significant difference. We find that DIA and SPY options seem to be more often used for hedging relative to their corresponding index options.

Index options: the early evidence. 22-1. 422-427. 50-2. 92-2.org/papers/w10264. 1991. Managing costs and risks with ETF tools. Whaley. Gurdip. Journal of Financial Economics. Robert. Andrea. 27-45.nber. Investor behavior and the option market. Matthew T. and Debojyoti Sarkar. 16-1. 1988. The American Economic Review. and Lewis. Nicolas P. and Stephen J. Whaley. Joseph. The behavior of the volatility implicit in the prices of stock index options. Shoven. 2002. pp. 20 . Engle. Review of Financial Studies. pp.References Bakshi. and Robert E. pp. 1997. Theodore E. The Review of Financial Studies. 29-1. Craig M. James M. http://www. NBER Working Paper 10264. The Journal of Derivatives. The term structure of volatility implied by foreign exchange options. Xu. Institutional Investor. 103-122. and the differential pricing of individual equity options. pp. Exchange-traded funds: a new investment option for taxable investors. Taylor. Evnine. 40-3. pp. (1998) The Relation Between Implied and Realized Volatility. Bent Jesper and Nagpurnanand R. Does net buying pressure affect the ahape of implied volatility functions? The Journal of Finance. 2003.. Xinzhong. 1985. pp. 101–43. Journal of Financial Economics.. 14-2. Buraschi. The Journal of Finance. Stock return characteristics. Overreactions in the options market. Excess volatility and closed-end funds. B. 46-4. Poteshman. 743-756. and Jens Jackwerth. 1551-1561. Christensen. Stein. 44. Lakonishok.4. Campbell R. 57-74. Moran. 125-150 Day. Prabhala. and Allen M. Harvey. 2004. and Andrew Rudd. skew Laws. 711-753. 2006. pp. 495-527. 87-1. Jeremy. The Journal of Finance. The price of a smile: hedging and spanning in option markets. The Journal of Finance. 2004. Jeremy. 59-2. pp. pp. Pontiff. 1994. The Journal of Financial and Quantitative Analysis. 1989. 14-27.. 1011-1023. and Robert E. Premiums-discounts and exchange traded funds. pp. Bollen. 2001.. pp. Jeffrey.. pp. Nikunj Kapadia. 2003. The American Economic Review. and John B. Inmoo Lee. 155-169. S&P 100 index option volatility. and Dilip Madan. pp. Poterba. 13-4.

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