Stock Option Returns and Stock Anomalies : Cross Market Efficiency and the Cost of Hedging Value vs Growth Firms Stock Returns

Year 2013, Volume: 2 Issue: 2, 5 - 12, 01.06.2013

Mick Swartz

Abstract

The empirical literature on stock returns shows overwhelming evidence of stock anomalies related to value investing. This paper studies the relative performance of stock options of value and growth stocks. This yields insight into different strategies in attempting to hedge some of these types of stocks.Monthly option returns are examined from 1995 to 2004. The returns of calls and puts are analyzed with a corresponding discussion of other strategies directly linked to these results. In particular, evidence is found that the option returns on some growth stocks and the option returns on some value stocks outperform the average option return for puts deep out of the money. For puts deep in the money, buying puts for the most extreme decile of value stocks is significantly less expensive than other deciles. For value stocks deep out of the money call options had significantly higher returns (20%) than growth stocks(negative option returns). For both puts and calls across the value and growth deciles, writing options had higher returns than buying options. Strategies with profitable returns over the decade included bear spreads using calls on value stocks and bull spreads on value stocks and growth stocks (but not the highest decile for growth). A third strategy that was profitable for the decade included buying deep out of the money puts for deciles 2, 3 (growth) and 10 (value). The relative cost of hedging stocks in the options markets does depend on value vs. growth characteristics

References

• Ball, R. 1978. Anomalies in Relationships Between Securities' Yields and Yield-Surrogates,
• Journal ofFinancial Economics 6, 103-26. Banz, R. 1981. The Relationship between Return and Market Value of Common Stock, Journal of
• Financial Economics 9, 3-18. Basu, S. 1977. Investment Performance of Common Stocks in Relation to their Price-Earnings
• Ratio: A Test ofthe Efficient Market Hypothesis, Journal of Finance, 32, June, 663-682. Blume, M. and R. Stambaugh. 1983. Biases in Computed Returns: An Application to the Size
• Effect, Journal ofFinancial Economics12, 387-404. Brennan, M.J. 1970. Taxes, Market Valuation, and Corporate Financial Policy, National Tax Journal 23, 417-27.
• Brennan, M.J., T. Chordia and A. Subrhmanyam. 1998. Alternative actor specifications security characteristic, and the cross section of stock returns, Journal of Financial Economics 49, 345-373.
• Carhart, M.M. 1997. On the persistence in mutual fund performance, Journal of Finance 52, 57
• De Bondt, W. and R. Thaler. 1985. Does the Stock Market Overreact? Journal of Finance 40, 793- 80
• De Bondt, W. and R. Thaler 1987.Further Evidence on Investor Overreactions and Stock Market
• Seasonality, Journal of Finance 42, 557-81. Fama, E. 1976.Foundations of Finance (Basic Books, New York).
• Fama, E. and K. French. 1992. The Cross Section of Expected Stock Returns, Journal of Finance 47, 427-466.
• Fama, E. and K. French. 1993. Common Risk Factors in the Returns of Stocks and Bonds, Journal of Financial Economics 33, 3-56.
• Fama, E. and K. French.Size, Value, and Momentum in International Stock Returns, National Bureau of Economic Research (NBER), 2011
• Graham, B. and D. Dodd. 1940. Security Analysis: Principles and Technique, McGraw-Hill Book
• Company, Inc., New York. Hawawini, G., and D. Keim. 2000. The Cross Section of Common Stock Returns: A Review of the Evidence and Some New Findings, in Keim, D.B. and W.T. Ziemba, Security Market
• Imperfections in Worldwide Equity Markets (Cambridge University Press, 2000).
• Jaffe, J., D. Keim and R. Westerfield. 1989. Earnings Yields, Market Values and Stock Returns,
• Journal of Finance 45, 135-148. Jegadeesh, N. and S. Titman. 1993. Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance 48, 65-92.
• Keim, D. 1983. Size-Related Anomalies and Stock Return Seasonality: Further Empirical
• Evidence, Journal of Financial Economics 12, 13-32. Kothari, S., J. Shanken and R. Sloan. 1995. Another Look at the Cross-Section of Expected Stock
• Returns, Journal of Finance 50, 185-224. Kuhn, T. 1970. The Stucture of Scientific Revolutions, (University of Chicago Press, Chicago).
• Lakonishok, J., A. Schleiffer, and R. Vishny. 1994. Contrarian investment, extrapolation and risk,
• Journal of Finance 49, 1541-1578.
• Litzenberger, R. and Ramaswamy, K. 1979. The Effects of Personal Taxes and Dividends on
• Capital Asset Prices: Theory and Empirical Evidence, Journal of Financial Economics, 163-195. Lo, A. and C. MacKinlay. 1990. When are Contrarian Profits due to Stock Market Overreaction,
• Review of Financial Studies 3, 175-205. Mehra, R. and E. Prescott. 1985. The equity premium: a puzzle Journal of Monetary Economics 15, 145-161.
• Miller, M. and M. Scholes. 1982. Dividend and taxes: Some empirical evidence Journal of Political Economy 90, 1118-41.
• Neiderhofer, V. and M.F.M. Osborne. 1966. Market making and reversal on the stock exchange,
• Journal of the American Statistical Association 61, 897-916. Reinganum, M. 1981. A Misspecification of Capital Asset Pricing: Empirical Anomalies Based on
• Earnings Yields and Market Values, Journal of Financial Economics 9, 19-46. Schwert, G.W. 2003.Anomalies and market efficiency, in G.M. Constantinides, M. Harris and R.
• Stulz, eds. Handbook of the Economics of Finance (Elsevier Science B.V.).