Pacific-Basin Finance Journal 38 (2016) 149–160

Contents lists available at ScienceDirect

Pacific-Basin Finance Journal

journal homepage: www.elsevier.com/locate/pacfin

Information content of investor trading behavior: Evidence from

Taiwan index options market
Yen-Hsien Lee a, David K. Wang b,⁎
a
Department of Finance, Chung Yuan Christian University, 200, Chung-Pei Road, Chungli 320, Taiwan
b
Department of Finance, National University of Kaohsiung, 700, Kaohsiung University Road, Kaohsiung 811, Taiwan

a r t i c l e i n f o a b s t r a c t

Article history: In this study, we analyze the information content of the TXO market using decoupled O/S ratio.
Received 25 March 2014 First, we find that, among four classes of traders, only foreign institutional investors have
Received in revised form 29 March 2016 significant predictive power in the TXO market, thereby providing evidence that foreign
Accepted 5 April 2016
investor flows do indeed have an impact on host-country stock returns. Second, the decoupled
Available online 13 April 2016
O/S (specifically, call O/S) ratio appears to outperform the overall O/S and put-call ratios as an
information-content variable. Third, we find that foreign institutional investors exhibit greater
Keywords: predictive ability with regard to the OTM and short-horizon TXO options, which implies that
Information content
leverage, rather than liquidity, is considered by the informed traders. To the best of our
Options trading
knowledge, this study represents the first of its kind to investigate the information content
Decoupled O/S ratio
Put-call ratio of decoupled O/S ratios in the index-option market.
Foreign institutional investors © 2016 Published by Elsevier B.V.

1. Introduction

Extant literature has suggested that the options markets attract informed trading because investors can benefit from high
leverage (see, e.g., Black (1975)), low transaction costs (see, e.g., Fleming et al. (1996)) and the flexibility to engage in a variety
of trading strategies that are unavailable to them in the spot market (see, e.g., Figlewski and Webb (1993), Chaput and Ederington
(2005) and Ni et al. (2008)).
Indeed, when investors choose to engage in informed trading within the options markets, the trading process may generate
rich information content on future stock prices. It is well documented that the prices of options play a leading role in price
discovery (see, e.g., Fleming et al. (1996), Easley et al. (1998) and Cao et al. (2005)), and that they are even capable of predicting
future price movements (see, e.g., Chakravarty et al. (2004), Pan and Poteshman (2006) and Chan et al. (2009)). Thus, our focus
in the present study is on the information content of options trading volume.
The Taiwan Stock Exchange (TAIEX) is one of the major exchanges in the emerging markets. In 2012, the TAIEX was ranked
twentieth in terms of market capitalization and fifteenth in terms of trading volume in the world. Furthermore, the Taiwan Market
Index Options (TXO), with the underlying asset being the TAIEX Weighted Stock Index (TWI), were ranked as the third most
frequently traded index options on a global scale.1

⁎ Corresponding author.
E-mail addresses: yh@cycu.edu.tw (Y.-H. Lee), dwang@nuk.edu.tw (D.K. Wang).
1
For detailed statistics, see the Statistics Section and Derivatives Market Survey available at the World Federation of Exchanges website: http://www.
worldexchanges.org/.

http://dx.doi.org/10.1016/j.pacfin.2016.04.001
0927-538X/© 2016 Published by Elsevier B.V.
150 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160

Prior studies (see, e.g., Richards (2005) and Barber et al. (2009)) have found that abnormal stock returns in the TAIEX are as-
sociated with foreign capital inflows, and foreign institutional investors are the main winners over other types of investors, whilst
Chang et al. (2009) and Hsieh and He (2014) go on to use TXO options transaction data to demonstrate that index options trading
by foreign institutional investors exhibit significant predictive power on the underlying TWI index returns, and foreign institution-
al investors are the most informed traders.2
Although in a large equity market (such as the U.S. market) it is unlikely that anyone might possess private information about
the market index (see, e.g., Richards (2005)), foreign capital flows in an emerging market (such as the Taiwan market) can be so
large that they might actually create price pressure and offer profitable opportunities for those who have access to the flow in-
formation (see, e.g., Chang et al. (2009)). For example, a foreign trader, who knew that a large mutual fund would increase its
portfolio weighting in the Taiwan market, may take advantage of this information to build long-call positions, which might
lead to capital inflows from informed traders in Taiwan's options market.
The empirical evidence provided by Chang et al. (2009) and Hsieh and He (2014) referred to above seems to suggest that trad-
ing volume plays a much more aggressive informational role in index options than had previously been suggested within other
studies (see, e.g., Schlag and Stoll (2005) and Pan and Poteshman (2006)).3 Our study can be viewed as an extension of the
Chang et al. (2009) and Hsieh and He (2014) studies, in which evidence has been found of predictive power in TXO options
among foreign institutional investors, particularly with regard to their trading positions in near-the-money and middle-horizon
options.
Our primary aim is to follow (and further modify) the methodology of Roll et al. (2010), in which the predictive ability of op-
tions volume is investigated by regressing the next τ-day index returns on the overall options/stock (O/S) trading volume ratio.4
The empirical model adopted for Chang et al. (2009) and Hsieh and He (2014), on the other hand, follows the methodology of
Pan and Poteshman (2006), in which the predictive ability of options volume is examined by regressing the next τ-day index
returns on the option put-call volume ratio.5
A common intuition is that call volume reflects good news and put volume reflects bad news. Johnson and So (2012) demon-
strate that this intuition does not hold, because informed traders buy calls and sell puts for good news, and buy puts and sell calls
for bad news.6 Unless trade direction is observable, it is unclear whether put/call volume reflects good or bad news. Moreover,
prior research (see, e.g., Brennan et al. (1998), Lee and Swaminathan (2000), Gervais et al. (2001) and Llorente et al. (2002))
have established that equity volume, the denominator of overall O/S, is useful by itself in predicting future returns.7 Thus, in
our study we follow the overall O/S ratio first developed by Roll et al. (2010) to examine the predictive ability of options volume.
To distinguish between good and bad news embedded in options trade, we further decouple overall O/S into separate measures
of call and put option volume: (1) call O/S ratio and (2) put O/S ratio. Our model makes prediction about the trading volume in
call (put) options and stocks together. As Ge et al. (2015) suggest that the embedded option leverage, rather than the equity
short-sale costs, is the most important channel why overall O/S predicts stock returns, we focus on informed traders' choice be-
tween call and put options as we formulate our hypothesis for call (put) O/S ratios. Therefore, our decoupled O/S ratio is the ratio
of call (put) option volume to equity volume, rather than the overall combined option volume to equity volume.
We begin by classifying the volume of all TXO options trading attributable to four classes of traders, namely, individual inves-
tors, market makers, foreign institutional investors and domestic institutional investors.8 We then examine the predictive ability
of the decoupled O/S ratio on next τ-day TWI index returns for each of these classes of traders.
First, our results indicate that the TXO trading volume provided by foreign institutional investors contains rich information re-
lated to future changes in the TWI index, whereas transactions by other classes of traders are found to be uninformative.9 This
finding is consistent with those of Griffin et al. (2004) and Richards (2005), in which the capital flows from foreign institutional
investors do indeed have significant predictive power with regard to next-day spot index returns, whereas flows from other types
of investors appear to have no significant predictive power. This finding is also consistent with Chang et al. (2009) and Hsieh and

2
Chou and Wang (2009) also identify a clear tendency for stealth trading among foreign institutional investors and proprietary firms in the index futures market in
Taiwan, a finding which implies that foreign institutional investors may well possess informational advantages related to aggregate market trend.
3
Schlag and Stoll (2005) find that the price impact of options volume on the DAX index is only a temporary phenomenon, thereby implying the presence of a liquidity
effect as opposed to an information effect. Pan and Poteshman (2006) also show that index options trading volume contains no information on future index movements,
whereas equity options trading volume has strong information content on future stock price movements.
4
Roll et al. (2010) show that the overall O/S ratio in the days immediately prior to earnings announcement predicts the magnitude of announcement returns, indi-
cating that overall O/S reflects traders' private information and can be used as an information variable.
5
Pan and Poteshman (2006) propose that the put-call ratio of options trading volume initiated by buyers, who open new positions, can be taken as an information
variable, since the options volume ratio is found to predict stock returns for the next five days, with both economic and statistical significance.
6
More specifically, Johnson and So (2012) find that informed traders buy puts for extremely bad news, sell calls for moderate bad news, sell puts for moderate good
news, and buy calls for extremely good news. We are sincerely thankful to the anonymous reviewer for bringing up this valuable point.
7
Specifically, Lee and Swaminathan (2000) show that high (low) volume winners (losers) experience faster momentum reversals, and Llorente et al. (2002) show
that the relation between equity volume and return autocorrelation changes sign depending on the amount of informed trading for a given equity.
8
We are sincerely thankful to the Taiwan Futures Exchange (TAIFEX) (website: www.taifex.com.tw) for making its TXO tick-by-tick dataset available to us. The
TAIFEX dataset includes detailed information on all transaction records within the TXO option market, which enables us to identify the different classes of investors.
9
We use option trades initiated by buyers to open new positions as our information variables. Since the entire informed traders (i.e., foreign institutional investors) in
the TXO option market account for about less than 10% of the total trading volume in open positions, there is no evidence of any relationship between the aggregate
option flows and underlying asset returns in Taiwan.
 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160 151

He (2014) with the results reported in the TXO market. Similar findings are also provided by Ahn et al. (2008), Kang and Park
(2008) and Lee and Wang (2012) with regard to trading in Korea's KOSPI index options.10
Second, we discover stronger predictive power in the call O/S ratios of foreign institutional investors on the TWI index changes.
The call O/S ratio appears to outperform the overall O/S and put-call ratios as an information-content variable.11 To the best of our
knowledge, this study represents the first of its kind to investigate the information content of decoupled O/S ratios in the index-
option market. Furthermore, the results of this study also contribute to a growing body of empirical literature (see, e.g., Stephan
and Whaley (1990), Easley et al. (1998), Chakravarty et al. (2004), Faff and Hillier (2005), Pan and Poteshman (2006), Chern et al.
(2008), Chan et al. (2009), Chang et al. (2009, 2010), Hsieh and He (2014) and Ge et al. (2015)), which have investigated the
linkage between the stock market and the option market.
Third, we also investigate into options leverage, which is seen as extremely important by a number of prior studies (see, e.g., Black
(1975), Chakravarty et al. (2004) and Kaul et al. (2004)), that have all suggested that this is the most important factor inducing informed
traders to trade in the option market. Specifically, we investigate whether informed traders use out-of-the-money (OTM) and short-
horizon options for higher leverage, and the evidence we have found is clear: the most significant predictability comes from the OTM
options and those mature under 30 days from the informed traders group. Our findings, which are consistent with Cao et al. (2005),
Pan and Poteshman (2006) and Ge et al. (2015), imply that leverage, rather than liquidity, is considered by the informed traders.12
Finally, we also examine the predictability of information variables constructed from different option volumes, and find that
open-buy provides better information variables than open-sell for testing the predictive power of informed traders.
The remainder of this paper is organized as follows. The dataset adopted for this study is described in Section 2, followed in Section 3
by a description of the methodology and hypotheses. The empirical results are presented and discussed in Section 4. Finally a summary of
the main results and the conclusions drawn from this study are provided in Section 5. Additional test results are reported in the Appendix.

2. Data and Descriptive Statistics

2.1. Main Dataset

The intraday (tick-by-tick) data analyzed in this paper have a complete record of every transaction of Taiwan Market Index
Options (TXO) between January 2, 2008 and March 31, 2009.13
The TXO options are European-style options, with the underlying asset being the Taiwan Stock Exchange Weighted Index (TWI).
Regular trading hours for TXO options run from 8:45 AM to 1:45 PM (Taiwan time).14 To minimize possible measurement errors aris-
ing from the different trading hours, we use TXO options data between the 9:00 AM and 1:30 PM stock trading hours. We also limit
the sample to options expiring at between 10 and 90 days. Options with maturities shorter than 10 days are excluded because of
position-squaring activities; options with maturities longer than 90 days are excluded because of thin trading (see, e.g., Chan et al.
(2009)). The total number of TXO intraday transactions in our sample is approximately 39,811,480 (over 307 trading days).
One of the unique features of our data is that the traders are identified on each side of TXO transactions. The traders are
classified as (1) domestic individual investors, (2) domestic institutional investors, (3) foreign institutional investors, and (4) mar-
ket makers. This detailed classification allows us to aggregate options volume attributable to different classes of traders, and helps
us to clearly distinguish between the motives behind each transaction. Moreover, since we focus on directional trades (i.e., plain-
vanilla option trades) to examine traders' motives, those non-directional trades (i.e., combination trades, such as spread, straddle,
and strangle trades) are excluded from our sample.15
Table 1 provides a summary of trading volume, with Panel A reporting the daily trading volume (in percentage terms) across
the four classes of traders and the time-series averages over 307 trading days.
As we can see from Panel A, trading volume differs significantly across the four classes of traders, with individual investors
being the major participants in the TXO market, accounting for 51.72% of the total volume. Market makers are the second largest
trader class,16 accounting for 26.17%, whilst foreign institutional investors and domestic institutional investors are the least active

10
For example, Ahn et al. (2008) argue that superior information processing skills and different interpretations of exactly the same public information may well result
in information asymmetry. They note that foreign institutional investors possess an informational advantage over other types of investors, and demonstrate a partic-
ularly large adverse selection component in the bid-ask spreads in KOSPI index options.
11
Our findings on the call O/S ratio are consistent with Miller (1977) that the stock price reflects only the views of investors with positive information or opinions. We
are sincerely thankful to the anonymous reviewer for bringing up this valuable point.
12
However, as indicated by Ge et al. (2015), the higher transaction costs for out-of-the money (OTM) options might also lead some traders to capitalize on their private
information by trading at-the-money (ATM) or in-the-money (ITM) options, depending on the content of the private information. Therefore, which moneyness cate-
gory of options has the strongest predictability could actually be an empirical question.
13
We are sincerely thankful to the Taiwan Futures Exchange (TAIFEX) (website: www.taifex.com.tw) for making its TXO tick-by-tick dataset available to us. The
TAIFEX dataset consists of a complete history of TXO options transaction records, providing investors' identification and class, option type (call/put), option character-
istics (such as strike price and time to expiration), trading direction (buy/sell), transaction price and volume. The same dataset was also employed by Chang et al.
(2009), Han et al. (2009), Chou and Wang (2009), and Hsieh and He (2014) to examine various issues in options trading on Taiwan's derivatives markets.
14
Regular trading hours for Taiwan stocks run from 9:00 AM to 1:30 PM.
15
These combination trades account for only b2% of the total trading records in the TAIFEX dataset.
16
All future proprietary firms are qualified to apply to be TXO option market makers. Their market maker accounts are separated from proprietary accounts, and have
some benefits of the commission fee deduction. After the first year of free commission fee, the fee deduction would be based on the market making volumes. Further-
more, the market making volumes must exceed the minimum monthly volume requirement (i.e., 500 lots), otherwise the market maker qualification might be revoked.
Therefore, a rational market maker would be devoted to provide quotations and market liquidity. This fact makes their incentive of trading different from the other
classes of traders.
152 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160

Table 1
TXO options volume, by different classes of traders and trading positions.
This table reports the details of TXO options volume distribution (in percentage terms) within the four classes of traders (i.e., foreign institutions, market makers, do-
mestic institutions, and individual investors) between January 2, 2008 and March 31, 2009. The distribution in Panel A is calculated by dividing the total trading volume
for each trader class (in number of contracts) by the volume for the overall market. The distributions in Panels B and C are calculated by dividing the volume for each
category (i.e., open-buy (or sell) call (or put) transactions) by the volume of the corresponding class of traders.

Variables Foreign institutions Market makers Domestic institutions Individual investors

Panel A: Overall distribution by trader classes

19.86 26.17 2.25 51.72

Panel B: Distribution by buy or sell

Buy 61.10 48.53 51.15 52.78
Sell 38.90 51.47 48.85 47.22

Panel C: Distribution by call or put

Buy call 27.60 23.93 25.98 27.82
Sell call 18.81 23.76 26.57 25.97
Buy put 33.51 24.60 25.17 24.96
Sell put 20.08 27.71 22.28 21.25

traders, respectively accounting for only 19.86% and 2.25%. The presence of such large numbers of uninformed retail traders pro-
vides opportunities for other more sophisticated traders to exploit their informational advantage.17
Details of the volume distribution for each of the four classes of traders in open-buy and open-sell transactions are provided in
Panel B of Table 1. We focus on open trades (including both open-buy and open-sell), because open trades are more likely to be
pursued by traders in possession of superior information on future price movements than do close trades (since open trades are
often used to establish new positions for speculating purposes in response to new information within the market). Conversely,
close trades (including both close-buy and close-sell) are regarded as being less aggressive, essentially because traders may exe-
cute such transactions as a means of realizing their gains or accepting their losses.
Furthermore, when engaging in open trades, buying options provides higher potential profits than selling options; therefore, traders
who aggressively trade on their informational advantage would tend to initiate more long positions in order to maximize their specu-
lative gains. Taking all of these factors together, open-buy transactions may well be used for informed trading, and are likely to have
much richer information content than other types of transactions (see, e.g., Pan and Poteshman (2006), and Chang et al. (2009)).
As shown in Panel B of Table 1, foreign institutional investors devote 61.10% of their trading volume to open-buy transactions,
a significantly greater proportion than that of any of the other three classes of traders. This substantially larger proportion of
open-buy trading indicates that foreign institutional investors are likely to possess superior information and aggressively use
open-buy option transactions in order to realize their informational advantage.
All transactions within each class of traders are further broken down, in Panel C of Table 1, into open (1) buy-call, (2) sell-call,
(3) buy-put and (4) sell-put transactions, with the proportions summing vertically to unity within each trader class. We find that for-
eign institutional investors hold substantially larger positions in long calls (27.59%) than short calls (18.81%), whereas the long- ver-
sus short-call volume is found to be evenly distributed for other classes of traders. A similar imbalance is also discernible in long put
versus short put volume for foreign institutional investors (33.51% versus 20.08%), but not for the other three classes of traders.
Since long calls (long puts) enjoy greater potential profits than short puts (short calls) when the underlying index moves up-
ward (downward), long positions are generally deemed to be the more aggressive positions (see, e.g., Pan and Poteshman,
2006).18 The substantially larger long option volume in the trading accounts of foreign institutional investors indicates that
these traders tend to be more aggressive than other traders, in terms of directional trading. We examine in later sections whether
the aggressive trading of foreign institutional investors is based upon their possession of superior information.

2.2. Open-buy Dataset

Open-buy transactions is the primary variable in our examination of the information content of trading volume, because informed
traders are very likely to open new positions in cases where they possess private information on the underlying asset. We calculate
the open-buy volume for call and put options across all available strike prices and times to expiration. We then examine whether the
four classes of traders tend to open-buy new positions, and if so, which type of options contracts they tend to use.
The percentage of open-buy trading volume from the various classes of traders is reported in Panel A of Table 2. The categories
of moneyness follow the classification of Pan and Poteshman (2006) to use 3% and 10% differences between strike and underlying
prices as cut-off points. As Panel A shows, investors tend to open a long position with more out-of-the-money (OTM) options than
in-the-money (ITM) options, with the highest proportion of open-buys occurring at near-the-money options. Furthermore,

17
If we were to exclude the market maker volumes, the structure of the TXO option market would comprise of around 70% individual investors and 30% institutional
investors.
18
Pan and Poteshman (2006) note that the predictive ability of option open-buy volume is found to be better than that of open-sell volume, and suggest that infor-
mation trading is likely to be implemented using long calls/puts, rather than short calls/puts.
 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160 153

Table 2
Open-buy positions, by different classes of traders and option types.
This table reports the percentage of open-buy trading volume from the various classes of traders. The numbers are the open-buy call (put) volume belonging to each
category as a percentage of the total open-buy call (put) volume for each trader class. In Panel A, OTM denotes out-of-money options, and ITM denotes in-the money
options. The 10% OTM call option is defined as a strike to index price ratio of 1.10, whilst the 10% OTM put option has an index to strike price ratio of 0.90. Near-the-
money refers to the call and put options having a strike to index price ratio between 0.97 and 1.03. In Panel B, time to expiration of each option is the period from each
trading day to the maturity of the corresponding option.

Variables Foreign institutions Market makers Domestic institutions Individual investors

Call Put Call Put Call Put Call Put

Panel A: Moneyness
Above 10% OTM 4.67 6.41 3.36 4.60 2.43 5.88 5.70 8.35
3–10% OTM 39.91 42.24 27.11 32.96 28.96 32.78 18.45 20.44
Near-the-money 47.22 43.79 53.47 42.24 55.69 49.74 55.86 53.77
3–10% ITM 6.50 5.36 13.53 12.50 10.07 8.43 19.99 17.25
Above 10% ITM 1.70 2.20 2.53 7.70 2.85 3.17 0.00 0.19

Panel B: Time to expiration

Under 30 days 67.20 67.57 86.42 86.89 88.91 91.02 85.60 89.01
30–60 days 29.10 28.73 12.89 12.07 9.33 7.93 14.40 10.99
Above 60 days 3.70 3.70 0.69 1.04 1.76 1.05 0.00 0.00

slightly OTM options are much more liquid than ITM options, although a little less liquid than near-the-money options. Consistent
with Kaul et al. (2004), deep-OTM options are less liquid than near-the-money and slightly OTM options.
From observation of the trading behavior of each type of trader, we find that foreign institutional investors trade most actively
in OTM options, whereas these options are traded least actively by individual investors. Chan et al. (2009) and Chang et al. (2009)
both find that leverage determines where informed traders would trade in the TXO option market and that the index returns are
led by OTM options. This feature motives us to examine whether the capital flows of foreign institutional investors do indeed
predict the underlying asset returns.
Panel B of Table 2 shows the percentage of open-buy trading volume from the different classes of traders across various times to
expiration of call and put options, revealing that most investors tend to trade in the nearby TXO options; this is probably because the
liquidity of the nearby contracts is much better than others, or because short-horizon contracts also provide higher leverage than others.
It is interesting to observe more active trading by foreign institutional investors in longer-horizon contracts (above 30 days) than in
other contracts. If there are larger spreads in long-horizon options, giving rise to higher transaction costs, we may speculate that foreign
institutional investors have very little concern over such high transaction costs.

3. Methodology and Hypotheses

3.1. Testing Information Content of TXO Options

Our empirical model follows the specifications of Roll et al. (2010) to assess the information content of TXO options;
i.e., whether the TXO option trading volume of different traders provides different information on the future movement of the
underlying TWI index.
We test the hypothesis using the following time-series regression:
Ri;tþτ ¼ α i þ βi Informationi;t þ γi Controli;t þ εi;tþτ ; τ ¼ 1; 2; 3; …; ð1Þ

where Ri,t represents the TWI index returns, Informationi,t are the information-content variables in TXO options trades (which is
valuable for predicting τ-days ahead TWI returns), and Controli,t are the control variables that may influence the TWI returns.19
We compute the TWI index returns using bid-ask quote midpoints to alleviate the potential issue of non-synchronous trading.20 The
TWI index is calculated by weighted-average market capitalization. We compute the market capitalization of each component in the TWI
index by taking (1) the number of outstanding shares of each company, and multiplying that number by (2) the company's current bid-
ask quote midpoint. As of January 2, 2008, the total number of the TWI index components is 668. We consider every component change
during our sample period (i.e., January 2, 2008 through March 31, 2009) in our computation of the TWI index.21

19
We follow Chang et al. (2009) to adopt four control variables which may influence the next τ-day TWI index returns: (1) an interaction term of the expiration dum-
my and the information variable; (2) the logarithm of daily closing index trading volume as a liquidity control variable; (3) the past five-day index cumulative return as
a reversal control variable; (4) the lagged one-day NASDAQ index return for controlling the correlation between Taiwan and U.S. markets.
20
Non-synchronous trading, first pointed out by Fisher (1966) and Scholes and Williams (1977), is a well-documented source of microstructure noise. In such case, the
last-trade prices (used to compute returns) may not reflect true asset values as at the close of trading, because for less frequently traded assets their prices may adjust to
available information only on the next coming transactions. Atchison, Butler, and Simonds (1987), Lo and MacKinlay (1990), and Kadlec and Patterson (1999), for ex-
ample, conclude that non-synchronous trading is capable of explaining only a portion of the observed autocorrelations between portfolio returns. We are sincerely
thankful to the anonymous referee for bringing up this valuable point.
21
The historical list of all stocks included in the TWI index can be found in the “Indices Monthly Statistics” section published on the official Taiwan Stock Exchange
(TWSE) website (website: www.twse.com.tw). The list, which shows every change in the TWI index since 1999, is updated every month (specifically, on the 7th trading
day of every month) as stocks are added/deleted from the index.
154 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160

We adopt the information variable of Roll et al. (2010) by assuming that the overall O/S ratio parsimoniously combines the
information of the option and its corresponding stock volumes; Informationi,t is therefore defined as:
Optioni;t
Informationi;t ¼ ; ð2Þ
Stocki;t

where Optioni,t and Stocki,t are the trading volume of TXO option i and TWI index i purchased by investors to open up new po-
sitions on date t.22 Johnson and So (2012) demonstrate a robust negative association between overall O/S and future equity
returns. They offer a simple explanation for this finding, specifically that low relative option volume (i.e., low overall O/S) indi-
cates good news because informed traders use equity more (and options less) frequently for positive private information than
negative one, due to the equity short-sale costs.23 We construct our hypothesis for overall O/S ratio based on these ideas:

Main hypothesis 1. If the flows of informed traders, as measured by overall O/S ratio, can predict the underlying TWI index
returns, then we would expect the coefficient βi for overall O/S ratio in Eq. (1) to be negative and significant.

Johnson and So (2012) indicate that informed traders buy calls and sell puts for good news, and buy puts and sell calls for bad
news. More specifically, they provide evidence that informed traders buy puts for extremely bad news, sell calls for moderate bad
news, sell puts for moderate good news, and buy calls for extremely good news. For extremely good or bad signals, informed
traders buy options despite large bid-ask spreads in these markets, because options provide greater leverage.24
Thus, to distinguish between good and bad news embedded in options trade, we decouple overall O/S into separate measures
of call and put option volume: (1) call O/S ratio and (2) put O/S ratio; Informationi,t is therefore defined as:

Calloptioni;t
Informationi;t ¼ ð4Þ
Stocki;t

Put optioni;t
or ð5Þ
Stocki;t

where Call (Put) optioni,t and Stocki,t are the trading volume of TXO call (put) option i and TWI index i purchased by investors to
open up new positions on date t. Eqs. (4) and (5) represent call and put O/S ratios, respectively. Our model makes prediction
about the trading volume in call (put) options and stocks together. As Ge et al. (2015) suggest that the embedded option leverage,
rather than the equity short-sale costs, is the most important channel why overall O/S predicts stock returns, we focus on
informed traders' choice between call and put options as we formulate our hypothesis for call (put) O/S ratios. Moreover, Pan
and Poteshman (2006) argue that open-buy transactions may well be used for informed trading, and are likely to have much
richer information content than other types of transactions. Thus, following Pan and Poteshman (2006), we examine primarily
the open-buy call (put) transactions for the information content of trading volume. As aforementioned, informed traders buy
calls (puts) for extremely good (bad) news, because options provide greater leverage than large bid-ask spreads in these markets
(see, e.g., Johnson and So (2012)). We construct our hypothesis for call (put) O/S ratios based on these ideas:

Main hypothesis 2. If the flows of informed traders, as measured by call (put) O/S ratio, can predict the underlying TWI index
returns, then we would expect the coefficient βi for call (put) O/S ratio in Eq. (1) to be positive (negative) and significant.25

22
We also examine the information variable of Pan and Poteshman (2006) by assuming that the put-call ratio parsimoniously combines the information of the put and
call volumes; Informationi,t is therefore defined as:

Put i;t
Informationi;t ¼ ;
Put i;t þ Calli;t

where Puti,t and Calli,t are the number of put and call contracts purchased by investors to open up new positions on date t for TXO option i. We use the new open po-
sition as the informed trader flows. We consider that if informed traders with positive information are able to take advantage of their information by building new long
call positions, this positive information would give rise to inflows from informed traders, and add to the total number of call contracts. Conversely, informed traders
would open-buy a put position when they want to realize their negative private information and increase the unobservable open-buy put-call ratio. We construct
our hypothesis for put-call ratio based on these ideas:

Main hypothesis 3. If the flows of informed traders, as measured by put-call ratio, can predict the underlying TWI index returns, then we would expect the co-
efficient βi for put-call ratio in Eq. (1) to be negative and significant.
23
Johnson and So (2012) also demonstrate that overall O/S is a stronger signal for future returns when short-sale costs are high or option leverage is low.
24
We are sincerely thankful to the anonymous reviewer for bringing up this valuable point.
25
As in the model of Miller (1977), if there exist both short-sale constraints and differences of information or opinions, the stock price reflects only the views of in-
vestors with positive information or opinions. Moreover, as evidenced by Ge et al. (2015), options' role in allowing investors with positive information about future
stock prices to obtain leverage is perhaps more important than their role in helping investors with negative information to avoid short-sale costs. Based on these ideas,
we take one step further to hypothesize that the call O/S ratio would predict the underlying returns better than the overall and put O/S ratios. We are sincerely thankful to
the anonymous reviewer for bringing up this valuable point.
 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160 155

3.2. Decomposing Information Content of TXO Options

In order to investigate which traders may possess superior information, we decompose the information variable into four
components, which are constructed by the open-buy overall O/S, call (put) O/S and put-call ratios of four of the classes of traders.
The regression is expressed as follows:

DIs DIs FIs FIs IIs IIs MMs MMs

Ri;tþτ ¼ α i þ βi Informationi;t þ βi Informationi;t þ βi Informationi;t þ βi Informationi;t þ γi Controli;t þ εi;tþτ ; ð6Þ

where InformationDIs FIs IIs MMs

i,t ,Informationi,t ,Informationi,t ,and Informationi,t denote the open-buy overall O/S, call (put) O/S and put-call
ratios of domestic institutions, foreign institutions, individual investors, and market makers, respectively, in TXO options at date t.
More significant coefficients indicate higher predictability levels for those trader classes. We expect that foreign institutional in-
vestors demonstrate the greatest predictability, followed in the second place by domestic institutional investors, with individual
investors providing the least predictability. Market makers are often regarded as liquidity providers, and therefore, we expect
that their option trading volumes should not have any significant predictability.
It has been suggested that informed traders trade in the option market as a result of options leverage (see, e.g., Black (1975),
Chakravarty et al. (2004) and Kaul et al. (2004)). This motivates us to decompose the information variable of various trader classes
into groups of moneyness and time to expiration, and then separately reform predictive regressions of the following form:

Money DIs&Money
Ri;tþτ ¼ α i þ βi Informationi;t þγ i Controli;t þ εi;tþτ ; ð7Þ

Money FIs&Money
Ri;tþτ ¼ α i þ βi Informationi;t þγi Controli;t þ εi;tþτ ; ð8Þ

Money IIs&Money
Ri;tþτ ¼ α i þ βi Informationi;t þγi Controli;t þ ε i;tþτ ; ð9Þ

Money MMs&Money
Ri;tþτ ¼ α i þ βi Informationi;t þγ i Controli;t þ εi;tþτ ; ð10Þ

Time DIs&Time
Ri;tþτ ¼ α i þ βi Informationi;t þγ i Controli;t þ εi;tþτ ; ð11Þ

Time FIs&Time
Ri;tþτ ¼ α i þ βi Informationi;t þγi Controli;t þ εi;tþτ ; ð12Þ

Time IIs&Time
Ri;tþτ ¼ α i þ βi Informationi;t þγ i Controli;t þ εi;tþτ ; ð13Þ

Time MMs&Time
Ri;tþτ ¼ α i þ βi Informationi;t þγi Controli;t þ εi;tþτ ; ð14Þ

where Ri ,t+τ is the next τ-day TWI spot-index return, InformationDIs&Money(Time)

i, t /InformationFIs&
i ,t
Money(Time)
/InformationIIs&Money(Time)
i ,t /
InformationMMs&Money(Time)
i,t is the information variable of domestic institutional investors/foreign institutional investors/individual inves-
tors/market makers constructed by open-buy volume with different moneyness (time to expiration). As there is general agreement in
the literature that both OTM and short-horizon options provide higher leverage, we expect that informed traders would trade OTM
and short-horizon TXO options to take advantage of their privative information. Therefore, the coefficient of OTM and short-horizon op-
tions (i.e., βMoney
i and βTime
i ) should be more significant than the coefficient of ITM and longer-horizon options.26

4. Empirical Results and Discussions

4.1. Predictability of the Overall Market

The overall market predictability regression (Eq. (1)) indicates whether options volume can predict future returns. In order to
estimate information variables, we follow Roll et al. (2010), Johnson and So (2012) and Pan and Poteshman (2006) to calculate
the daily open-buy overall O/S (Eq. (2)), call (put) O/S (Eqs. (4) and (5)) and put-call (Eq. (3)) ratios, respectively.27
26
As shown in Table 2, foreign institutional investors trade most actively in OTM TXO options; hence, it is reasonable to expect the most significant negative coefficient
for the foreign institutional investors group. Furthermore, using time to expiration as another variable for options leverage, we expect that short-horizon (i.e., under
30 days) TXO options, which provide higher leverage, would have better predictive power than longer-horizon options.
27
Similar to Johnson and So (2012), our regression analyses use daily decile △O/S measures, that are constructed by (1) partitioning the △O/S ratios into deciles, and
(2) setting the decile variables equal to 1, 2, …, 10, accordingly, where 1 corresponds to the smallest decile and 10 to the largest. The △O/S measures, △O/Si,t, are de-
fined as O/Si,t -O/Si,t-5.
156 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160

Table 3 reports the results of Eq. (1). In Table 3, we are unable to find any significant predictability within one week for the
overall O/S, put O/S, and put-call ratios. This is hardly surprising. Since, in the case of index options, the underlying index essen-
tially diversifies away any firm-specific information, it would then be difficult for aggregate trading activities to reveal any private
information for individual stocks (see, e.g., Chang et al. (2009)). However, we do find significant predictability at the leading two
days for the call O/S ratio.
To further investigate longer periods of information content, we extend the predictability horizon and find that all ratios have
shown little predictability. Our test of overall market predictability supports the hypothesis (i.e., Main hypothesis 2) that the call
O/S ratio has predictive power to future stock returns.

4.2. Predictability of Each of the Trader Classes

We examine which traders may possess superior information (i.e., predictability) by reinvestigating Eq. (1) and jointly running
the regressions of Eq. (6). We calculate the next two-day compounded returns for TWI spot index (i.e., τ = 2),28 following the
results reported in Table 3.29 Table 4 shows the summarized results.
We find that only call O/S ratios from foreign institutional investors provide significant predictive power, with a coefficient of
0.1526, and a p-value of 0.0127. It is interesting to note that individual investors account for about half of the overall volume
(i.e., 51.72%) as reported in Table 1, but their trades do not contain any significant information. On the other hand, despite the
fact that foreign institutional investors account for only a small proportion of the total volume (i.e., 19.86%), their trades provide
significant predictive power with regard to leading returns. This is direct evidence that flows from foreign institutional investors
can predict the underlying asset returns in the Taiwan market.30

4.3. Predictability With Varying Options Leverage

As it has been suggested that informed traders trade in the option market as a result of options leverage (see, e.g., Black
(1975), Chakravarty et al. (2004) and Kaul et al. (2004)), we classify the put and call options based upon their moneyness and
time to expiration, and re-examine the predictability for each of the trader classes.31
Panel A of Table 5 reports the predictability results for each trader class with options volume of varying moneyness, as
specified in Eqs. (7)–(10). As it is shown in Table 2 that foreign institutional investors trade relatively more in OTM TXO options
than any other classes of investors, we expect that the information variables constructed from those OTM options should exhibit
return predictability.
Our results confirm our expectation. As indicated by call O/S ratios, whilst the near-the-money options trading undertaken by
foreign institutional investors are positively related to the next two-day return at the 0.05 significance level,32 the strongest
information content for next two-day index returns comes from OTM options at the 0.01 significance level,33 which implies
that leverage, rather than liquidity, is considered by the informed traders.34
Nevertheless, there is no return predictability in the ITM option trading. For overall O/S and put O/S ratios, we find little
evidence of information trading.35
Panel B of Table 5 reports the findings of the information content of options volume with different times to expiration, as specified in
Eqs. (11)–(14). Although Panel B of Table 2 shows that most investors tend to trade in the nearby short-horizon (i.e., under 30 days) TXO
options, we find that only the trading volume of foreign institutional investors is significantly related to the next two-day index returns
(at the 0.01 significance level), as indicated by call O/S ratios.36
Moreover, we find slightly significant coefficients of middle-horizon (i.e., 30–60 days) TXO options from domestic institutional
investors (as indicated by put-call ratio), and no significant predictive power for the market makers and individual investors.

28
The next two-day TWI spot-index return, Ri, t+2,is computed as ð1 þ Ri; tþ1 Þ  ð1 þ Ri; tþ2 Þ  1, where Ri; tþ1 is the TWI spot-index return on date t + 1,
and Ri; tþ2 is the TWI spot-index return on date t + 2.
29
As indicated in Table 3, there is significant predictability at the leading two days for the call O/S ratio.
30
As a test of robustness, we also undertake analysis of the next-day TWI spot-index returns (i.e., τ = 1) and find similar results.
31
As there is general agreement in the literature that both OTM and short-horizon options provide higher leverage, we expect that informed traders would trade OTM
and short-horizon TXO options to take advantage of their privative information.
32
The highest proportion of open-buys also occurs at near-the-money TXO options, as indicated in Panel A of Table 2.
33
Our findings on call O/S ratios are consistent with those of Black (1975), Chakravarty et al. (2004) and Chang et al. (2009), who find that informed agents prefer to
trade in OTM option contracts.
34
In order to examine the robustness of the relative predictive power of near-the-money and OTM options, we also run various regressions for call O/S ratios of foreign
institutional investors. Results are shown in Appendix Table 1. As we can see in Appendix Table 1, the OTM options have indeed consistently stronger predictive power
(at a consistent 0.01 significance level) on all of the regressions than the near-the-money options.
35
Our findings on put-call ratios (for market makers) are similar to Chang et al. (2009), in that they also find significant predictability in near-the-money options (for
foreign institutional investors, nonetheless). However, unlike their study, we do not find significant predictability in OTM TXO options for domestic institutional inves-
tors and market makers.
36
As aforementioned, with a given level of moneyness, short-horizon options offer higher leverage than longer-horizon options. This implies that leverage, rather than
liquidity, is considered by the foreign institutional investors. As Barber et al. (2009) indicate in their study, trading in short-horizon options are more likely to be for
speculation rather than for hedging purpose, because it is more efficient for investors to hedge their equity exposure using options with maturity closer to their invest-
ment horizon. Nonetheless, foreign institutions tend to use index options to hedge their long-equity positions, because foreign institutions are not allowed to short in the
stock market (see, e.g., Han et al. (2009)). We are sincerely thankful to the anonymous reviewer for bringing up this valuable point.
 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160 157

Table 3
Predictability of information-content variables.
This table reports the slope coefficients of time-series regressions of the τ-days ahead TWI spot-index returns on the investor's open-buy overall O/S, call (put) O/S and
put-call ratios. The control variables are omitted here to save space.

Days ahead Overall O/S ratio Call O/S ratio Put O/S ratio Put-call ratio
(+τ)
Coeff. p-Value Coeff. p-Value Coeff. p-Value Coeff. p-Value

1 0.0440 0.3209 0.0546a 0.0948 0.0337 0.4671 −0.0013 0.9261

2 0.0995 0.1043 0.0847b 0.0490 0.1006 0.1295 0.0140 0.3164
3 0.0097 0.8272 −0.0184 0.6711 0.0438 0.3465 0.0363 0.1095
4 0.0551 0.2167 0.0309 0.4763 0.0841 0.1706 0.0000 0.9995
5 −0.0111 0.8039 −0.0463 0.2843 0.0081 0.8621 0.0049 0.7284
6 −0.0284 0.5186 −0.0415 0.3315 −0.0177 0.7006 0.0039 0.7808
7 −0.0383 0.3898 −0.0230 0.5945 −0.0450 0.3336 0.0065 0.6440
8 −0.0043 0.9227 0.0009 0.9841 −0.0194 0.6764 0.0074 0.6016
9 0.0108 0.8092 0.0113 0.7945 −0.0016 0.9732 0.0138 0.3263
10 0.0716 0.1033 0.0618 0.1485 0.0621 0.1771 0.0142 0.3063
a
Coefficients are significant at 0.1 level.
b
Coefficients are significant at 0.05 level.
c
Coefficients are significant at 0.01 level.

Table 4
Predictability of each of the trader classes.
The table reports the results of time-series regressions of the next two-day TWI spot-index returns on the open-buy overall O/S, call (put) O/S and put-call ratios for each trader
class. The control variables are omitted here to save space. One, two and three asterisks respectively indicate that the coefficients are significant at the 0.1, 0.05 and 0.01 level.

Traders Overall O/S ratio Call O/S ratio Put O/S ratio Put-call ratio

Coeff. p-Value Coeff. p-Value Coeff. p-Value Coeff. p-Value

Foreign institutions 0.1554 0.1135 0.1526** 0.0127 0.1335 0.1364 −0.0010 0.9069
Market makers 0.0375 0.5558 0.0734 0.2332 0.0564 0.3988 0.0055 0.6630
Domestic institutions 0.0636 0.3352 0.1380 0.1241 0.0724 0.2777 −0.0039 0.5135
Individual investors 0.0601 0.3606 0.0762 0.2372 0.0714 0.2846 0.0575 0.1105

4.4. Predictability for Open-sell Transactions

If informed traders possess positive information on the overall market, they can either open-buy a new call or sell a put to re-
alize their prediction. The former adds to the total number of contracts in open-buy call options and increases (reduces) the open-
buy call O/S ratio (put-call ratio) such that the next τ-day index returns are expected to rise, whilst the latter adds to the total
number of contracts in open-sell put options and increases both the open-sell put O/S and put-call ratios. Thus, we also examine
the information content of open-sell option volume type.
The coefficients of joint regressions by trader classes are presented in Table 6. As indicated by call O/S ratio, the coefficient on
the open-sell volume for foreign institutional investors turns out to be positive, with little significance.
It is not surprising that we observe an incorrect (although insignificant) sign for open-sell option volume for foreign institu-
tional investors. As noted by Lakonishok et al. (2004), many of the open-sell positions are part of the cover-call strategies, as op-
posed to direct speculation about the future price of underlying assets. As such, the open-sell option volume would contain
complex trading information, which would result in the distorting/weakening of the predictive results by such noisy signals.
Furthermore, as noted in Chang et al. (2009), investors prefer to buy rather than sell put options (since buying put is often
adopted to deal with short-selling restrictions). Also, to many investors, buying call options is more straightforward to establish
a long position than selling put. Hence, we would expect little significant predictability in the regression on open-sell positions
than on open-buy volume, as is the case indicated by Table 6.
In summary, we conclude that the information in open-buy volume is more informative than open-sell volume, in particular
with regard to the results for foreign institutional investors.

5. Concluding Remarks

In this study, we analyze the information content of the TXO market using decoupled O/S ratio. Our major findings include that
(1) among four classes of traders, only foreign institutional investors have significant predictive power in the TXO market, thereby provid-
ing evidence that foreign investor flows do indeed have an impact on host-country stock returns37; (2) the decoupled O/S (specifically,
call O/S) ratio appears to outperform the overall O/S and put-call ratios as an information-content variable (to the best of our knowledge,

37
Our findings are in line with Chang et al. (2009) and Hsieh and He (2014), in which the TXO trading volume provided by foreign institutional investors contains rich
information related to future changes in the TWI index, whereas transactions by other classes of traders are found to be uninformative.
158 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160

Table 5
Predictability with varying options leverage, by trader classes.
The table reports the results of time-series regressions of the next two-day TWI spot-index returns on the open-buy overall O/S, call (put) O/S and put-call ratios for each
of the trader classes with different moneyness and time to expiration. The control variables are omitted here to save space.

Variables Overall O/S ratio Call O/S ratio Put O/S ratio Put-call ratio

Coeff. p-Value Coeff. p-Value Coeff. p-Value Coeff. p-Value

Panel A: Moneyness
Foreign institutions
Above 10% OTM 0.1655 0.1070 0.1655c 0.0075 0.0939 0.1385 0.0079 0.1017
3–10% OTM 0.0756 0.2310 0.0462 0.4537 0.0630 0.3226 −0.0026 0.7082
Near-the-money 0.1497 0.1155 0.1217b 0.0474 0.1439 0.1217 −0.0006 0.9402
3–10% ITM 0.0058 0.9256 0.0720 0.2427 −0.0155 0.8083 −0.0056 0.3259
Above 10% ITM −0.0846 0.1987 −0.0598 0.4429 −0.1010 0.1918 0.0189 0.1420
Market makers
Above 10% OTM 0.1544 0.1145 0.1454 0.1417 0.0482 0.4467 0.0121 0.1111
3–10% OTM 0.0733 0.2476 0.0764 0.2259 0.0494 0.4357 −0.0002 0.9785
Near-the-money −0.0269 0.6652 0.0254 0.6795 −0.0342 0.6025 −0.0192a 0.0596
3–10% ITM 0.0957 0.1246 0.0301 0.6312 0.0826 0.2148 0.0062 0.3058
Above 10% ITM 0.1963 0.1015 −0.0387 0.5566 0.1497 0.1237 0.0052 0.3792
Domestic institutions
Above 10% OTM 0.0508 0.4230 −0.0243 0.7684 −0.0276 0.7049 0.0084 0.1958
3–10% OTM −0.0214 0.7358 0.0402 0.5138 0.0028 0.9643 0.0056 0.2556
Near-the-money 0.1578 0.1172 0.0939 0.1330 0.0408 0.5552 −0.0010 0.8331
3–10% ITM −0.1604 0.1720 −0.0375 0.8165 −0.7216 0.1234 −0.0180 0.3489
Above 10% ITM −0.0872 0.7262 −0.1966 0.5572 0.1858 0.6678 −0.0029 0.9323
Individual investors
Above 10% OTM 0.1345 0.1408 0.1280 0.1789 0.0024 0.9700 0.0157 0.1282
3–10% OTM 0.1080 0.1843 0.0982 0.1164 0.1069 0.1882 0.0005 0.9721
Near-the-money 0.1032 0.1927 0.1051 0.1865 0.0847 0.1844 −0.0021 0.8654
3–10% ITM 0.0855 0.1673 0.0529 0.3891 0.1124 0.1898 −0.0031 0.7101
Above 10% ITM 0.1061 0.1873 0.0376 0.5689 0.0357 0.6258 0.0252 0.1089

Panel B: Time to expiration

Foreign institutions
Under 30 days 0.1003 0.1498 0.1887c 0.0053 0.0850 0.2294 0.0056 0.3993
30–60 days 0.0079 0.8978 0.0553 0.3663 0.0164 0.7899 0.0021 0.7294
Above 60 days 0.0403 0.5140 −0.0059 0.9246 0.0295 0.6342 0.0046 0.3606
Market makers
Under 30 days 0.0547 0.4301 0.0427 0.5330 0.0543 0.4475 0.0093 0.2556
30–60 days −0.0762 0.2108 −0.0158 0.7995 −0.0829 0.1851 −0.0057 0.4186
Above 60 days 0.0594 0.3768 0.0014 0.9863 0.0596 0.4312 0.0053 0.3565
Domestic institutions
Under 30 days 0.1164 0.1982 0.1581 0.1203 0.1094 0.1213 0.0077 0.1900
30–60 days −0.1202 0.1000 −0.1392 0.1548 −0.0977 0.2362 −0.0094a 0.0589
Above 60 days −0.2803 0.1266 −0.4573 0.1081 0.2546 0.4949 −0.0095 0.5378
Individual investors
Under 30 days 0.0772 0.2600 0.1174 0.1842 0.1704 0.1147 0.0184 0.1533
30–60 days −0.0548 0.3803 −0.0881 0.1578 −0.0680 0.2694 −0.0014 0.9147
Above 60 days 0.1076 0.1865 0.1266 0.1431 0.0131 0.8336 0.0117 0.1043
a
Coefficients are significant at 0.1 level.
b
Coefficients are significant at 0.05 level.
c
Coefficients are significant at 0.01 level.

Table 6
Predictability from open-sell options volume.
The table reports the results of time-series regressions of the next two-day TWI spot-index returns on the open-sell overall O/S, call (put) O/S and put-call ratios for each
trader class. The control variables are omitted here to save space. One, two and three asterisks respectively indicate that the coefficients are significant at the 0.1, 0.05
and 0.01 level.

Traders Overall O/S ratio Call O/S ratio Put O/S ratio Put-call ratio

Coeff. p-Value Coeff. p-Value Coeff. p-Value Coeff. p-Value

Foreign institutions 0.0940 0.1392 0.0564 0.3585 0.0775 0.2400 −0.0028 0.7577
Market makers 0.0863 0.1749 0.0802 0.1915 0.0883 0.1903 0.0114 0.3631
Domestic institutions 0.0380 0.5517 0.0663 0.2920 0.0587 0.3529 0.0070 0.4791
Individual investors 0.1153 0.1753 0.1129 0.1775 0.1080 0.1976 0.0447 0.1624
a
Coefficients are significant at 0.1 level.
b
Coefficients are significant at 0.05 level.
c
Coefficients are significant at 0.01 level.
 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160 159

this study represents the first of its kind to investigate the information content of decoupled O/S ratios in the index-option market)38;
and (3) the most significant predictability comes from the OTM and short-horizon TXO options from the foreign institutional investors,
which implies that leverage, rather than liquidity, is considered by the informed traders.39
Our findings contribute to a growing body of empirical literature (see, e.g., Stephan and Whaley (1990), Easley et al. (1998), Chakravarty
et al. (2004), Faff and Hillier (2005), Pan and Poteshman (2006), Chern et al. (2008), Chan et al. (2009), Chang et al. (2009, 2010), Hsieh and
He (2014) and Ge et al. (2015)), which have investigated the linkage between the stock market and the option market.
In all, our study sheds some light on the foreign capital flows in the option markets, which may have predictive power with
regard to the underlying asset returns. Also, our investigation may provoke further study of the information content of index-
option markets, which are generally viewed as being less informative than individual stock markets.

Acknowledgements

The authors are sincerely grateful to the editor, Prof. S. Ghon Rhee, and the anonymous referee whose helpful comments have
led to significant improvement on the content and exposition of this paper. Financial support from the Ministry of Science and
Technology of Taiwan (MOST-101-2410-H-033-011), and data support from the Taiwan Futures Exchange (TAIFEX) is also grate-
fully acknowledged. All remaining errors are ours.

Appendix A

In order to examine the robustness of the relative predictive power of near-the-money and OTM options, we run various re-
gressions for call O/S ratios of foreign institutional investors.40 Appendix Table 1 summarizes the results. As we can see in Appen-
dix Table 1, the OTM options have indeed consistently stronger predictive power (at a consistent 0.01 significance level) on all of
the regressions than the near-the-money options.41

Appendix Table 1
Predictability of near-the-money and OTM trading of foreign institutional investors with control variables. The table reports the results of time-series regressions of the
next two-day TWI spot-index returns on the open-buy call O/S ratio for near-the-money and OTM trading of foreign institutional investors with control variables. The
controls include (1) the expiration dummy interacting with call O/S ratio, (2) the logarithm of daily closing index trading volume, (3) the five-day index return, and
(4) the lagged one-day NASDAQ index return.

Intercept Call O/S ratio (1) (2) (3) (4) R2

Interaction control Liquidity control Reversal control Correlation control

Coeff. p-Value Coeff. p-Value Coeff. p-Value Coeff. p-Value Coeff. p-Value Coeff. p-Value

Panel A: Above 10% OTM options trading

−26.1208b 0.0128 0.1712c 0.0057 0.0031 0.8574 1.6288b 0.0180 −0.0658 0.1100 . . 0.0505
−15.7895a 0.0960 0.1854c 0.0025 0.0049 0.7742 0.9492 0.1266 . . 0.0832 0.2268 0.0470
−18.2891b 0.0486 0.1881c 0.0022 0.0043 0.8011 1.1116a 0.0673 . . . . 0.0422
−1.2698c 0.0010 0.1737c 0.0051 . . . . −0.0353 0.3448 0.1205a 0.0815 0.0420
c c
−1.3189 0.0006 0.1816 0.0034 . . . . −0.0201 0.5811 . . 0.0320
c c
−1.2996 0.0007 0.1832 0.0028 . . . . . . 0.1054 0.1172 0.0391
b c
−24.1497 0.0220 0.1655 0.0075 0.0036 0.8316 1.5019b 0.0300 −0.0750a 0.0713 0.1020 0.1414 0.0576

Panel B: Near-the-money options trading

−28.0145c 0.0080 0.1224b 0.0467 −0.0038 0.8274 1.7714b 0.0104 −0.0897b 0.0284 . . 0.0385
−14.5205 0.1290 0.1140a 0.0650 −0.0015 0.9296 0.8935 0.1545 . . 0.0890 0.2001 0.0280
a a
−17.1777 0.0664 0.1151 0.0626 −0.0023 0.8967 1.0668a 0.0823 . . . . 0.0225
−0.9807b 0.0106 0.1208b 0.0491 . . . . −0.0565 0.1283 0.1342a 0.0535 0.0289
−0.9900b 0.0102 0.1214b 0.0491 . . . . −0.0405 0.2660 . . 0.0164
−0.9149b 0.0166 0.1157a 0.0597 . . . . . . 0.1106 0.1031 0.0212
−25.7864b 0.0151 0.1217b 0.0474 −0.0030 0.8614 1.6258b 0.0193 −0.0991b 0.0163 0.1127 0.1056 0.0471
a
Coefficients are significant at 0.1 level.
b
Coefficients are significant at 0.05 level.
c
Coefficients are significant at 0.01 level.

38
Our results on the decoupled call O/S ratio are consistent with Miller (1977) that the stock price reflects only the views of investors with positive information or
opinions. We are sincerely thankful to the anonymous reviewer for bringing up this valuable point.
39
Our findings on the predictability of the OTM options are in line with Cao et al. (2005), Pan and Poteshman (2006) and Ge et al. (2015). However, as Ge et al. (2015)
point out in their study, the higher transaction costs for out-of-the money (OTM) options might also lead some traders to capitalize on their private information by trad-
ing at-the-money (ATM) or in-the-money (ITM) options, depending on the content of the private information. Therefore, which moneyness category of options has the
strongest predictability could actually be an empirical question.
40
As aforementioned, we follow Chang et al. (2009) to adopt four control variables which may influence the next τ-day TWI index returns: (1) an interaction term of
the expiration dummy and the open-buy call O/S ratio; (2) the logarithm of daily closing index trading volume as a liquidity control variable; (3) the past five-day index
cumulative return as a reversal control variable; and (4) the lagged one-day NASDAQ index return for controlling the correlation between Taiwan and U.S. markets.
41
It can be noted that (1) there is no significant additional information at the expiration date; (2) trading volume has a positive and significant influence on next two-
day returns; (3) there is slightly significant reversal of index returns; and (4) a positive (and slightly significant) correlation exists between Taiwan and U.S markets, as
reported in previous studies.
160 Y.-H. Lee, D.K. Wang / Pacific-Basin Finance Journal 38 (2016) 149–160

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