What Academic Researchers Discovered About Options Trading Will Change How You Trade

The Crystal Ball in Plain Sight

Imagine if you could peek into the minds of the smartest money on Wall Street. What if there was a way to see what sophisticated traders really think about a stock's future, not what they say in interviews or write in reports, but what they actually bet their money on?

Well, it turns out there is. And it's hiding in plain sight in the options market.

Every day, millions of options contracts change hands. Some traders buy calls betting stocks will rise. Others buy puts wagering they'll fall. Most retail investors see this as random noise, a chaotic marketplace of speculation and gambling.

But researchers Benjamin Blau, Nga Nguyen, and Ryan Whitby discovered something remarkable when they analyzed this "noise." They found that certain patterns in options trading can actually predict which way stocks will move. Not perfectly, mind you, this isn't a get-rich-quick scheme. But with enough reliability to give traders a genuine edge.

Their findings challenge what many of us thought we knew about options markets and reveal why timing your analysis might be more important than the analysis itself.

The Tale of Two Ratios

The story revolves around two deceptively simple numbers that Wall Street professionals have been watching for years:

The Put-Call Ratio (P/C): This measures how many put options are trading compared to call options. When it's high, it means lots of people are buying puts, betting the stock will fall. When it's low, calls dominate, suggesting optimism.

The Option-to-Stock Volume Ratio (O/S): This compares total options volume (both puts and calls) to the actual stock trading volume. High ratios suggest options traders are particularly active relative to stock traders.

Both ratios have been used by traders for decades. But nobody had ever done a head-to-head comparison to see which one actually works better at predicting stock movements. That's exactly what these researchers set out to discover.

The Daily Battle: Put-Call Ratio Takes the Crown

When the researchers examined daily trading patterns, they uncovered something that might surprise options veterans: the put-call ratio crushes the option-to-stock ratio at predicting next-day stock movements.

Here's what they found: When stocks had high put-call ratios (lots of put buying relative to calls), those stocks significantly underperformed the next day. The effect was so strong that stocks in the highest put-call ratio group had returns 40% worse than those with high option-to-stock ratios.

Think about what this means. When you see heavy put buying in a stock, it's not just random speculation. It's often informed traders positioning for bad news they expect to hit soon. And that bad news tends to arrive within 24 hours.

The Bottom Line for Daily Traders: If you're looking for signals about tomorrow's stock performance, watch the put-call ratio more closely than overall options volume.

The Weekly Reversal: A Plot Twist

But here's where the story gets interesting, and where many traders go wrong.

When the researchers looked at weekly patterns instead of daily ones, everything flipped. Suddenly, the option-to-stock ratio became the better predictor, while the put-call ratio's crystal ball began to fog up.

Stocks with high weekly option-to-stock ratios underperformed the following week by twice as much as stocks with high weekly put-call ratios. The very metric that dominated at the daily level became the weaker signal at the weekly level.

This isn't a statistical fluke. It reveals something profound about how information flows through options markets and why the timeframe of your analysis matters enormously.

The Monthly Truth: When Signals Disappear

By the time the researchers examined monthly patterns, the put-call ratio had lost its predictive power entirely. Meanwhile, the option-to-stock ratio continued showing reliable negative correlations with future stock performance.

Monthly put-call ratios? Useless for prediction. Monthly option-to-stock ratios? Still working.

This creates a fascinating paradox: the ratio that works best for daily predictions becomes worthless for monthly forecasting, while its competitor maintains steady predictive power across longer timeframes.

Why This Happens: The Information Decay

The explanation lies in understanding what these ratios actually measure and how quickly that information gets absorbed by the market.

Put-Call Ratios: The Sprint Signal Put-call ratios appear to capture very time-sensitive information, the kind that gets acted upon quickly. When informed traders pile into puts because they expect bad earnings or negative news, that information typically surfaces within days. Once it's public, the predictive power evaporates.

Think of put-call ratios as capturing "hot" information with a short shelf life. They're incredibly valuable for short-term predictions but decay rapidly.

Option-to-Stock Ratios: The Marathon Indicator Option-to-stock ratios seem to reflect broader, more persistent concerns about a stock's fundamental value or longer-term prospects. This information takes weeks or months to fully work its way through stock prices.

These ratios capture "slow-burning" information that doesn't get arbitraged away as quickly.

The Practical Implications

This research has profound implications for how options traders should approach the market:

For Day Traders and Swing Traders:

• Focus on put-call ratios when looking for short-term moves

• High put-call ratios often signal impending weakness within 1-2 days

• Don't expect these signals to work beyond a week

For Position Traders and Investors:

• Watch option-to-stock ratios for longer-term insights

• High option-to-stock ratios can signal trouble weeks or months ahead

• Put-call ratios won't help you with longer-term positioning

For All Traders:

• Match your timeframe to your metric, this might be the most important lesson

• Don't assume a signal that works daily will work weekly or monthly

• Information in options markets has different "half-lives"

The Deeper Lesson: Markets Are Layered

This research reveals something beautiful about financial markets: they're not uniform. Different types of information flow through different channels at different speeds.

Some information, like impending earnings surprises or management changes, moves fast and gets reflected in put-call ratios. Other information, like deteriorating business fundamentals or industry headwinds, moves more slowly and shows up in option-to-stock ratios.

Successful traders need to understand these layers. They need to know which signals to trust for which timeframes, and when to ignore signals entirely.

The Warning Labels

Before you rush off to build trading strategies around these insights, remember the fine print:

Past Performance Doesn't Guarantee Future Results: These patterns held true in historical data, but markets evolve. What worked in the past might not work forever.

Statistical Significance Isn't Trading Significance: The effects, while real, are measured in basis points. You're not going to get rich overnight using these signals alone.

Execution Matters: Knowing a stock might underperform tomorrow doesn't automatically translate into profitable trades. You still need proper risk management, position sizing, and execution skills.

Market Conditions Change: These relationships might strengthen or weaken depending on overall market volatility, economic conditions, and regulatory changes.

The Bottom Line

The options market is constantly broadcasting signals about future stock movements. But like a radio picking up different frequencies, you need to tune into the right signal for your timeframe.

For immediate moves, listen to the put-call ratio. For longer-term trends, tune into the option-to-stock ratio. And remember: the loudest signal today might be silent next month.

This research doesn't hand you a money-printing machine. But it does give you a more sophisticated understanding of how information flows through options markets, and that understanding, properly applied, can give you a genuine edge in your trading.

The markets are constantly teaching us. The question is: are we listening to the right lessons at the right times?

Acknowledgments and Further Reading

This article is based on the groundbreaking research paper "The Information Content of Option Ratios" by Benjamin M. Blau (Utah State University), Nga Nguyen (Texas Tech University), and Ryan J. Whitby (Utah State University). Their meticulous analysis of over 5 million stock-day observations represents the kind of rigorous academic work that advances our understanding of how markets really function.

We owe a debt of gratitude to researchers like Blau, Nguyen, and Whitby who dedicate their careers to uncovering the hidden patterns in financial markets. While traders are busy executing strategies, these academics are in the trenches, crunching massive datasets to reveal truths that can benefit all market participants. Their work reminds us that successful trading isn't just about gut instincts, it's about understanding the underlying mechanics of market behavior.

Access the Original Research: The complete paper is available through the Social Science Research Network (SSRN) at: https://www.ssrn.com/index.cfm/en/

For those interested in diving deeper into the methodology, statistical analysis, and detailed findings, the full academic paper provides extensive tables, regression analyses, and robustness tests that support the conclusions discussed here.

Continue Your Options Education

Understanding market dynamics like these option ratios is just one piece of building a comprehensive trading approach. If you're serious about improving your options trading skills and learning from experienced practitioners who study this research, consider joining a community of like-minded traders.

The Income Foundation offers exactly this kind of ongoing education, where members discuss practical applications of academic research, share real-world trading experiences, and learn from seasoned professionals, all for less than the cost of a couple of coffee shop visits each month. It's the kind of environment where insights like these get turned into actionable strategies.

Probabilities over predictions,

Andy Crowder

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