Leveraging a call-put ratio as a trading signal

Patrick Houlihan, Germn G. Creamer

Stevens Institute of Technology

{phouliha, gcreamer} @stevens.edu

December 2014

Abstract
We examine whether a particular put-call ratio, derived from a unique set of market data, can be used
to predict directional moves in asset prices during various market conditions between March 2005 and
December 2012. Our findings show: 1) specific market participant option trading volume is shown to
be a predecessor to asset price movements; and 2) portfolios adjusted for risk, momentum and
transaction costs exhibit abnormal excess returns. These findings suggest that short positions of a
specific market participant improve the overall performance of a given portfolio.
"What seems too high and risky to the majority generally goes higher and what seems low and cheap generally goes lower."
- William J. O'Neil
Buy low and sell high. Its pretty simple. The problem is knowing whats low and whats high.
- Jim Rogers
Keywords: Behavioral finance, investors sentiment, financial forecasting.

I. INTRODUCTION
Information present in news diffuses over a period of time according to Zhuo et al. (2013), Hou
(2007), Maheu et al. (2004), and Chan 2004) in contrast to the semi-strong form of the efficient
market hypothesis (EMH) (Fama, 1970), which states that prices fully reflect all publically

Electronic copy available at: http://ssrn.com/abstract=2363475

available information. The strong-form of the EMH represents a perfectly efficient market where
all information, both inside and publically available, are fully reflected into assets price and no
investor, regardless if armed with insider information, can achieve abnormal returns. However,
Fama et al. (1969) showed that stocks experienced periods of abnormal returns prior to publically
available company announcements. In addition, on the day of the announcement, the diffusion of
news occurs quickly as the market adjusts the assets price based on potential future cash flows.
Its also worth mentioning stock split announcements are common for companies to announce the
same day as future dividends, these future dividends provide an incentive to market participants to
buy the asset, further adding premium to an assets price. This latter study suggests investors
(perhaps a specific investor type) had access to insider information and clearly profited prior to
any official announcement. The assets price clearly did not fully reflect all inside information until
the actual day of the announcement, as further gains were realized. Previous day gains are most
likely attributable to a select few investors or perhaps a specific trader who were privy to this
information and whose buying behavior lead that of other investor types, specifically uniformed
investors. Furthermore, on the day of the announcement, additional price adjustments occurred as
the news spread quickly -to the masses who were able to further evaluate the future cash flows,
thus, the demand for the asset causes an adjustment in its fundamental value. This study was also
conducted prior to the mass adoption of the internet where millions now have access to news
releases.

In addition, Lou (2014) and Barber et al. (2008) have shown that abnormal returns

occurs on stocks with a lot of media buzz, including media pessimism (Tetlock 2007) leading to
downward pressure, and showed that illiquid stocks exhibited the highest out of the abnormal
returns (Fang et al. 2009).

Electronic copy available at: http://ssrn.com/abstract=2363475

Cutler et al. (1989) suggest news accounts for approximately one-third of asset price volatility and
price changes which are not solely explained by fundamental factors. Rather, some other factors
must be contributing to the other two-thirds of the volatility. Delong et al. (1990, 1990a) suggests
that the remainder two-thirds of an assets price volatility is explained through noise traders and
positive feedback traders. Positive feedback traders create more volatility, thus forcing assets
prices further away from their true fundamental value upon news being injected into the market,
and with a slight lag as compared to rational speculators. Understanding this behavior, rational
speculators, will aggressively drive up the price on the day of the news announcement in
anticipation of the positive feedback participants entering the market a short time thereafter. All
of this momentum forces the assets price further away from the true fundamental value, enabling
the rational speculators to sell at a higher price and leaving the positive feedback trader with
inventory whose demand is diminishing. Soon thereafter, the assets price will efficiently return
close to its fundamental value based on specific company news (Fama 1991). Following the
rational speculator and positive feedback trader, over to their effects on volume and expected
returns, Campbell et al. (1993) show that stock price declines are more likely to occur on a high
volume day versus a low volume day.

The injection of news into the marketplace in conjunction with various trader behavior help explain
both the volatility and evolution of an assets price. This research focuses on both a practical and
theoretical approach by creating a measure, trading signal, which contains a component of both
investor sentiment and behavior. Our research adjusts the returns for risk, momentum and
transaction costs (as a function of shares bought and sold) to properly capture a more realistic alpha
versus previous results based on univariate-regression (Pan et al. 2006). We will show this trading

signal for a particular trader, when used in short only strategies, yields abnormal returns when
compared to holding the benchmark.

II. LITERATURE REVIEW

Sentiment indicators are harnessed to predict future price movements. Anthony (1988) has shown
that increased trading in call options leads to next day gains in various underlying stocks that
experienced a spike in call volume the day prior. The latter research would warrant using call
option volume as a feature for a model to predict a label, such as future directional moves. Cao et
al. (2003) find that option volume imbalances, specifically, short-term out of the money call option
volumes are predictors of pending takeovers. This finding points to somewhat of an inefficient
market, one where only informed traders have access to insider information prior to announcement.
However, this inefficiency can be leveraged as an indicator to a model that attempts to predict a
label such as the next day directional move. One such indicator, known as the put-call ratio, has
been shown to yield abnormal gains (Billingsley et al. 1988). The put-call ratio, PCR, is simply
the total daily put volume (behavior) divided by the daily call volume (behavior) for a particular
equity. Intuitively, a ratio below 1.0 would point to a bullish indicator, whereas a ratio above 1.0
points to a bearish indicator. However, Bandopadhyaya et al. (2011) and Billingsley et al. (1988)
show that a ratio of 0.7 is a better threshold. Additionally, the PCR seems to be more of a
contrarian indicator than a conformist indicator, in fact several other indicators are contrarian in
nature, including short-term interest, and VIX. The PCR is thought to be a short-term sentiment
on the future move of a particular stock or index. Hu (2013) shows that imbalances between option
volume and underlying volume predicts future stock returns. Pan et al. (2006) also show that
volume, for specific traders, was determined to contain information about future prices. This latter
study had access to a unique data set that showed new buyer volume (behavior), broken out by
4

various traders. Unique put-call ratios were derived using each particular trader. The data (19902001) was analyzed using a univariate regression, where the independent variables are the
corresponding put-call ratios and the dependent variable is the next day risk adjusted return. The
results showed stocks with a low put-call ratios, derived from a particular trader (full-service),
outperformed stocks with high put-call ratios by +40 basis points (bps), on the next day and 1%
over the following week. The premise here is that informed, full-service, investors trading the
underlying stock in lieu of index options have firm specific related news rather than market-wide
news. Also, stocks that went through periods of higher breadth (advancing issues relative to
declining issues) rewarded investors with abnormal returns of 2.92% in 6 months and 4.95% in a
12-month period (Chen et al. 2002). The former and latter studies are in stark contrast to index
options, where Han (2004) shows the opposite effect. Market-wide and firm-wide sentiment seem
to be contrarian and conformist in nature respectively.

Han (2004) shows that these sentiment indicators, specifically, the bull-bear spread (investor
intelligence), net position of large speculators and the fractional deviation of S&P 500 index to
that of the Campbell and Shiller forecasted value, all affect S&P index option prices. Index options
are quite expensive, so typically it is professional investors buying and selling index options.
Many of these sentiment indicators, when they peak in value, actually act as contrarian indicators
(Lamont et al. 2004, Tsuji 2009, Simon et al. 2001).

During bear markets, periods of extreme fear or high put-call ratios, are prime buying opportunities
due to lots of cash being on sidelines during bear markets. In bear periods like these, the premise
is when any positive news is released, it causes a huge influx of money back into the markets
(Simon et al. 2001). Whereas, in bull markets, most money is already in the market, so when
5

positive news is released, the gains are not as robust as they are during bear markets when positive
news is released.

In the capital markets, market sentiment can be measured through a number of different indicators
from the VIX, to the put-call ratio. These are just two examples among many which are indicators
of market sentiment. Table I lists some of the more popular sentiment indicators.
Table I. Market Sentiment Indicators
Sentiment Indicator
Volatility Index (VIX)

Put-call ratio (PCR)

Bull-Bear Spread (IIS)

Barrons Confidence Index (BCI)
Risk Appetite Index (RAI)

Definition
VIX is a measure of implied volatility of front month and second month expiration out-of-the-money
put and call options. Calculated every minute. Known as a fear factor gauge (Whaley, 2000). High
volatility is indicative of uncertainty.
Put option volume divided by Call option volume. Billingsly et al. (1988) showed that values over
0.7 are bearish signals and values under 0.7 are bearish signals. Similar to the reciprocal of the ISE
ratio used in this research, but the PCR uses all option volume data, regardless of trader or trade
size.
Weekly survey of 150 newsletters marked as bullish, bearish or neutral based on future expected
returns. Clarke et al. (1998) showed as author sentiment shifts from bearish to bullish is a proxy for
future significant returns.
Average yield on high-grade bonds divided by average yield of intermediate grade bonds.
Lashargi (2000) leverages this ratio as a market confidence indicator.
Based on rank correlation across assets riskiness and excess returns. Kumar et al (2002) showed
that investors risk appetite changes over time and is measurable. > 0 positive, < 0 negative

Survey polling ~500 people monthly about their opinion of the near-term health of the economy.
Consumer Confidence Survey (CCI) This index could have been used to predict the recession of 1991 (Batchelor et al., 1998).
Benchmarked to 100%. > 100% optimism < 100% pessimism
Traders Index (TRIN)

Arms 1989 showed an oversold market equates to volume in declining stocks that far outweigh
volume in advancing stocks. Short-term indicator = (advancing issues/declining issues) /
(advancing volume/declining volume). < 1 bullish, > 1 bearish

Short Interest (SIR)

Total number of shares shorted, in term of percentage of total outstanding shares, high % bearish,
low % bullish. Kerrigan (1974) showed a correlation between SIR and asset returns.

Out of all the market data derived sentiment indicators, this paper evaluates if various call-put ratio
strategies, derived from trader option volume, are proxies of investor sentiment and anticipate
price changes. We use a particular call-put ratio, the ISE Sentiment Index 1 in our calculations.
This ratio is similar to the put-call ratio which helps explain pricing variations that are not captured

The ISE Sentiment Index (ISEE) is a unique put/call value calculated using only opening long customer
transactions to determine bullish/bearish market direction.

by various fundamental factors (Bandopadhyaya et al. 2011), implying that the put-call ratio is
capturing a component of investor behavior. This is a deviation away from the efficient market
hypothesis (Fama, 1970), which makes no mention of a human behavior component to future price
changes.

III. DATA
Our asset price data is from the University of Chicagos Center for Research in Security Prices
(CRSP) database. We also used a unique dataset provided by ISE Holdings 2 which consists of
firm-wide daily option volume data broken out by various traders, below.
Customer: Option trade volume for traders acting on behalf of discount and full-service customers.
Broker Dealer: Option trade volume for traders acting on behalf of institutional clients.
Proprietary: Option trade volume for proprietary 3 traders acting on behalf of their own firm.
Professional 4: Option trade volume for Non-Registered Broker Dealer traders whose daily average
is about390 trades (high frequency traders).
The professional trader was broken out into a separate analysis between October 2009 and
December 2012, a summary can be found in section VII.
The data is further broken down into four transaction types:

Opening buy Buying a call or put option, new position.

Closing buy Buying a long position to close out.

Opening Sell Selling (writing) a call or put option, new position.

Closing Sell Selling a long position to close out.

As a starting point and following Pan et al. (2006), opening buy data for equity options was used
to derive the daily call-put ratio for each trader.

ISE Holdings is the International Securities Exchange Holding company that operates two U.S. option exchanges:
International Securities Exchange, LLC and Topaz Exchange, LLC
3
Proprietary traders trade firm money
4
Data only provided for Professional trader between October 2009 and December 2012

While the ISE has a 16.8% market share (see Table II) for option volume trading , there is no one
single exchange that constituted more than 30% of the option volume in any given period. One
assumption for using the data from ISE, is that neither exchange fragmentation nor does
concentration exist that affects the price discovery process. To lessen the perceived impact of this
assumption, OHara et al. (2011) have shown that fragmentation does not cause an inefficient
marketplace. In fact, that research showed that fragmentation increased competition between the
exchanges (clearly seen in market share breakdowns over the years) and helped induce
competitive spreads and trade execution.
Table II. Equity & Exchange Traded Funds Electronic Market Option Market Share

This table shows end of year market share breakdowns, in percentage %, for electronic option exchanges.

DATE
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12

ISE
29.60%
27.44%
28.11%
28.32%
21.50%
17.25%
15.92%
16.75%

GEMINI
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%

AMEX
10.82%
9.52%
6.51%
5.52%
9.75%
11.32%
14.53%
15.56%

BOX
5.35%
4.12%
4.72%
6.69%
1.85%
2.78%
3.49%
2.90%

CBOE
24.71%
25.83%
26.07%
27.84%
26.40%
20.10%
16.78%
16.22%

ARCA
14.63%
14.63%
16.29%
11.88%
15.11%
11.75%
13.14%
11.68%

PHLX
14.89%
18.46%
18.31%
17.85%
22.69%
30.05%
28.16%
24.77%

NOM
0.00%
0.00%
0.00%
1.90%
2.70%
4.67%
4.20%
5.76%

BATO
0.00%
0.00%
0.00%
0.00%
0.00%
1.30%
2.51%
3.85%

C2OX
0.00%
0.00%
0.00%
0.00%
0.00%
0.76%
1.26%
1.43%

BX
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
1.06%

Customer traders, for open buy order types on both call and put option types, dominate option
volumes, with 66.69% and 62.99%, respectively, for the entire available data set (see Table III). In
addition, the average volume for the order type, Open Buy, being the dominant order type. Pan et
al. (2006) showed that the full-service trader, Customer Trader, also dominated the option volumes,
and was shown to be the strongest predictor of future gains.

Table III. Trader Composition

This table shows each traders average put and call volume (option contracts) for all four order types. In addition, we break the data further out to
see the percentage breakdowns to see what trader is driving the majority of the volume.

Average volume
Proprietary
Customer
Broker Dealer

May 2005 to December 2012

Open Buy
Open Sell
Close
Put
Call
Put
Call
Put
41.28
45.56
38.42
39.16
14.46
22.97% 21.46% 25.09% 22.50% 18.77%
62.99% 66.69% 58.70% 64.21% 74.20%
14.03% 11.85% 16.21% 13.29% 7.02%

Buy
Close Sell
Call
Put
Call
15.33
16.63
21.44
15.84% 13.89% 12.52%
78.64% 80.54% 83.09%
5.52% 5.57% 4.39%

We run the Bai-Perron (1988) regression test across the timeframe of our data set to identify
structural breaks of the SPY series. The test yielded three sub-periods which are consistent with
market data before, during and after the financial crisis:
May 2005 to May 2008
May 2008 to September 2010
September 2010 to December 2012
Capturing the analysis across all of these sub-periods helps determine if any ISE call-put ratio
contains more information during a specific sub-period and naturally captures any traders behavior
shift. In addition, we explore a robust sample of market conditions, from normal to severe.
IV. METHODOLOGY
We run the augmented Dickey-Fuller (ADF) unit-root test to check for presence of stationarity,
for all assets log return series. Then we calculated the ISE call-put ratio or the ISE Sentiment Index
call-put ratio for every trader using the open buy order transaction types in the following formula:
ISE =

where,

LONG CALLS (Opening Position)

LONG PUTS (Opening Position)

= trader specific call volume

= trader specific put volume
9

We used various option volume filters (total contract volume) to capture if a certain thresholds of
option contract volume would yield a higher Sharpe ratio. Pan et al. (2006) used a minimum volume
of 50 contracts to construct put-call ratios in order to prevent small volumes from dictating the ratio
values. We used a similar methodology but expanded that to include volume values of 50, 100 and
any positive value to formulate the call-put ratios. This will capture varying levels of trade
conviction and their impact on the Sharpe ratio.

In total, we used the ISE call-put ratio in 27 simulations which include all traders with the following
variations for our data set:
-

Bottom 8 stocks ISE value (L ISE)

Top 8 stocks ISE value (H ISE)
Top 4 and Bottom 4 stock ISE value (LH ISE)
Above were separately simulated for call and put option volume cut-offs, filters:
o 50: Option contract volume sizes >= 50
o 100: Option contract volume sizes >= 100
o All: Any option contract volume size

Each simulation followed this trading strategy:

Every day, the initial value of our portfolio is USD 1 million, regardless of the result of the day
prior. Assuming the ISE to be a conformist indicator, any low categorized ISE values (low ISE)
result in taking a short position and any long categorized ISE values (high ISE) result in a long
position at the open price into the following day and spread equally, leading to an initial investment
of USD 125,000 for each security. We liquidated our portfolio at the end of the day at the close
price; so transaction costs consistent with the NYSE of 0.0023 per share 5 were incurred on both
entry and exit, open and close, twice per security. Daily and cumulative returns are calculated each
day for both the overall portfolio and the benchmark until we reach the end of the series. Using

Per: http://www.nyse.com/pdfs/nyse_equities_pricelist.pdf the equity per share charge; per transaction is $0.0023

10

realized return data, we calculated annualized return and the ex-post Sharpe ratio. We used SPY,
an exchange traded fund which reflects both the price and yield performance of the S&P500, as our
benchmark. Across the full test period, between May 2005 and December 2012, the SPY has a
correlation and R2 with the S&P500 index of 0.99.

We also calculated alpha or excess return in relation to the fair expected return using the three
factor Fama and French (1993) model and the four factor Carhart (1997) model. To evaluate if a
binary predictor, the ISE signal in this case, is a robust predictor of the price direction, we used
the Matthews correlation coefficient (MCC) (Matthews 1975) whose null hypothesis stipulates
that a binary classifiers accuracy is by random chance:
=
where,

TPxTN FPxFN

( + )( + )( + )( + )

TP true positive, forecasted true and actual true

TN true negative, forecasted false and actual false
FP false positive, forecasted positive and actual negative
FN false negative, forecasted negative and actual negative
V. RESULTS
The ADF test validated that all log return time series are stationary, further transformations were
not required.
The simulations with 50 contracts and all contracts (> 0) to construct put-call ratios for our data set
yielded the highest Sharpe ratios of 0.98 and 0.91, respectively (see Table IV). Simulations with 50
contracts support findings that volume contains information about future stock returns (Campbell
et al. 1993, Easley et al. 1998, Cao et al. 2003, Pan et al. 2006 and Johnson et al. 2012). Small
volume is most likely coming from smaller market participants and large volume from larger market
11

participants. Typically, the larger the market participant the more informed they are (Easley et al.
1987 and Barclay et al. 1993) as they have more resources at their disposal.
Table IV. Average Sharpe Ratios for Trading Strategies
This table shows the average Sharpe ratios (for all traders) for the various trading strategies. The data is filtered by the volume of option
contracts traded. Any daily contract volume that did not meet the filter value, i.e. >= 50 or >= 100, was not included in the analysis.

May 2005 to Dec 2012

Filter
>0
>= 50
>= 100

L ISE

0.91
0.98
0.76

H ISE

-0.92
-0.43
-0.38

LH ISE

0.11
0.02
-0.09

The original assumptions, high ISE ratio (H ISE) implies taking a long position, conformist, and
low ISE ratio (L ISE) implies taking a short position. The H ISE only simulation, yielded negative
Sharpe ratios for all traders across the entire data set.

The L ISE simulations show a stark contrast to that of the H ISE. Every L ISE simulation for our
data set yielded positive Sharpe ratios, except for SPY showing a slight negative Sharpe during the
sub-period between May 2008 and September 2010, which coincided with the financial crisis
(Table VI). Regardless of trader, all traders ISE ratios yielded positive Sharpe ratios. The financial
markets did suffer substantial losses during the crisis, and logically short strategies would have
benefited the most from short strategies. However, regardless of the simulation, the conformist
view (L ISE) performed quite well, regardless of market conditions, across all simulated subperiods: pre, during and post financial crisis. This strongly supports the assumption of a conformist
L ISE which was correct throughout our data set.

Looking at the mixture simulation, both H ISE and L ISE, the results are an expected mixture of
the two aforementioned simulations. Clearly, the H ISE strategy weighed down the overall results,
showing small negative and positive Sharpe ratios for broker dealer and proprietary trader ratios
12

but positive Sharpe ratios for the customer trader ratio. One can ascertain such results by simply
adding Table VI together to yield such results. Due to the L ISE strategy, the customer trader ratio
performed so well, and even when mixed with the H ISE ratio for the same period, still resulted in
a positive Sharpe ratio.

All simulated returns, for all traders and sub-periods, were all run through an additional set of
experiments to determine the average return when the signal correctly and incorrectly predicted the
directional move of the underlying; the results are summarized in Table V. The L ISE ratio strategy
performed quite well, and exhibited an average return of 298.89 bps higher when classified
correctly versus incorrectly.
Table V. Average Return and Excess Return
This table shows the average next day (after event day) day return when the assumption was correctly forecasted in either shorting (L ISE) or
going long (H ISE) for each trader. Difference between correct and incorrect returns is in basis points.

Customer
Broker Dealer
Proprietary
Average

L ISE
Correct
Incorrect
Gain
Gain
1.94%
-1.78%
0.83%
-0.64%
1.97%
-1.81%
1.58%
-1.41%

Mean Return
H ISE
LH ISE
Correct
Incorrect
Correct
Incorrect
Gain
Gain
Gain
Gain
2.00%
-2.14%
0.13%
0.18%
0.63%
-0.85%
0.06%
0.10%
1.86%
-1.97%
0.05%
0.17%
1.49%
-1.65%
0.08%
0.15%

Difference between Correct and Incorrect

L ISE
H ISE
LH ISE
371.46
413.52
-4.34
146.59
147.70
-3.68
378.62
382.32
-12.12
298.89
314.51
-6.71

Table V supports strong Sharpe ratios observed for all traders, across all sub-periods when adhering
to our original assumption of shorting stocks that exhibit the lowest ranked ISE ratios (L ISE). For
instance, the average gains were 1.58% for L ISE while the average gains were 1.49% for H ISE.
Table VI. Simulations - Sharpe Ratios by Trader and Sub-Period
This table shows the annualized Sharpe ratios for our data set across all sub-periods. Each result seen below is granulized by specific sub-period,
trader, strategy and filter. The benchmark (SPY) annualized Sharpe ratio is at the bottom row.
Trader Type
Customer
Broker Dealer
Proprietary
SPY

May 2005 to May 2008

L ISE
H ISE
LH ISE
1.50
-0.69
0.99
0.93
-1.42
-0.19
0.97
-1.49
-0.42
0.79

May 2008 to September 2010

L ISE
H ISE
LH ISE
0.72
-1.51
-1.04
-0.35
0.47
-0.76
0.14
0.61
-0.94
-0.04

13

September 2010 to December 2012

L ISE
H ISE
LH ISE
1.40
-1.06
0.77
0.63
-0.64
0.34
-0.98
0.89
0.00
0.81

May 2005 to December 2012

L ISE
H ISE LH ISE
1.09
-1.09
0.13
0.63
-0.89
-0.13
0.74
-1.07
-0.09
0.37

The three factor Fama-French and four factor Carhart models presented in Table VII validates our
results. The L ISE and H ISE strategies yield the largest number of simulations with positive and
negative alpha respectively, while the LH strategy yields mixed results, even after adjusting the
returns for the risk-free rate and momentum. It can be conjectured that the use of the L strategy
does yield abnormal gains, especially the customer trader has both the highest Sharpe ratio and
alpha values (1.09 and 1.081 respectively) across our data set.
Table VII. Alpha of 3 factor Fama-French and 4 factor Carhart Models by Trader
This table shows the returns adjusted for either the risk free rate or momentum effects. There are three sets of numbers, separated by a pipe symbol, |,
the first grouping represents the LH strategy, the second the L strategy and the third the H strategy. * and ** indicate if the coefficients are different
from zero with a significance level of 5% and 1% respectively.
FAMA-FRENCH 3 FACTOR
May 2005 to May 2008
May 2008 to September 2009 September 2009 to December 2012 May 2005 to December 2012
L ISE
H ISE
LH ISE
L ISE
H ISE
LH ISE
L ISE
H ISE
LH ISE
L ISE
H ISE LH ISE
Customer
0.72
0.01
0.25
1.63** -2.54**
0.36
1.05**
-0.66
0.38
1.09** -0.97**
0.32
Broker Dealer
0.49
-0.76
-0.29
1.54*
-2.31**
-0.18
1.28**
-0.70
0.28
1.06** -1.22**
-0.07
Proprietary
0.52
-0.08
0.36
2.31** -1.79**
0.31
0.55
-1.08**
0.03
1.08** -0.91**
0.25
772
579
577
1928
Days
CARHART 4 FACTOR
May 2005 to May 2008
May 2008 to September 2009 September 2009 to December 2012 May 2005 to December 2012
L ISE
H ISE
LH ISE
L ISE
H ISE
LH ISE
L ISE
H ISE
LH ISE
L ISE
H ISE LH ISE
Customer
0.60
-0.04
0.28
1.71** -2.66**
0.34
1.04**
-0.62
0.36
1.08** -0.96**
0.32
Broker Dealer
0.36
-0.74
-0.35
1.68** -2.38**
-0.16
1.23**
-0.68
0.26
1.05** -1.21**
-0.08
Proprietary
0.43
-0.05
0.36
2.40** -1.78**
0.27
0.54
-1.08**
0.01
1.08** -0.91**
0.25
772
579
577
1928
Days

VI. PROFESSIONAL/HIGH FREQUENCY TRADER

As of October 2009, professional trader data was available. These traders make at least 390 trades
per day and here we will consider them to be high-frequency traders, HFT. In the study of the flash
crash of May 6, 2010, Kirilenko et al. (2011) defines HFT as the top 7% transactional traders on a
daily basis. HFTs will close positions before market close, and in fact, Chlistalla (2001) shows that
most HFTs are opening and closing trades within 22 seconds. Additionally, HFTs are not chasing
long-term trends, but rather they are chasing short-term trends and provide liquidity to the
marketplace.

14

An additional analysis was run to determine if an ISE call-put ratio, derived from this trader, can
be used as a proxy for future asset returns. For comparison purposes, we also included the original
three traders. The period run was between October 2009 and December 2012. Considering this
was the beginning of the recovery period, we decided to run simulations across the entire period
only with no sub-periods.
Table VIII. Simulations - Sharpe Ratios by Trader and Period
This table shows the annualized Sharpe ratios and returns for our data set across our entire data set. Each result is granulized by specific subperiod, trader, strategy and filter. The benchmark (SPY) annualized Sharpe ratio is at the bottom row.

Trader Type
Customer
Broker Dealer
Proprietary
Professional
SPY

October 2009 to December 2012

L ISE
H ISE
LH ISE
1.17
-1.36
0.00
0.51
-0.68
-0.03
-1.04
0.93
-0.05
-1.47
-0.41
-0.59
0.69

The professional trader exhibited a negative Sharpe ratio for all three trading strategies (Table VIII).
The main reason for this result is that the ISE ratio that we used is based on a daily aggregate of
option volumes, therefore it would not capture intraday trading behavior of a professional-HFT
trader. However, ISE Holdings does have intraday data available, every 15 minutes, and capturing
short-term trends through formulation of the professional trader type is possible. This will be an
area to explore for future research.

VII. DISCUSSION OF INVESTOR SENTIMENT

Pan et al. (2006) showed that the largest additional 10 bps gain happened over the next week. The
additional gains for the short strategy, L ISE, especially for the customer trader, extended to day 2.
Accumulative average return of 13.71 and 14.95 bps was observed on day 2 versus 12.68 and 3.16
bps for day 1 (Table IX). Looking out to 60-days post event day, this strategy exhibited reversal
and incurred the largest losses of -21.68 and -108.79 bps. The long strategy, H ISE, did exhibit the
15

worst next day gains of, -7.5 bps. However, by day 5, reversal was observed and exhibited the
largest gains of 17.2 bps while by day 60, gains of 288.85 bps was observed. The mixture signal,
LH ISE, cumulative gain also experienced reversal course five days out and exhibited positive gains
of 22.43 bps and by 60-days gains of 135.94 bps.

Table IX. Average Cross-Sectional Returns

This table shows average cross sectional return, in basis points (bps), for all qualified stocks across a 60 day horizon after event day for the
respective trading strategy. Event day is when an assets ISE ratio qualifies for each respective trading strategy. That is stocks are selected for
each respective trading strategy by the following: for H, the top 8 highest ISE ratios, for L, the bottom 8 ISE ratios and for LH, the top 4 highest
ISE ratios and the bottom 4 ISE ratios.

Trader Type
L ISE
H ISE
LH ISE
ALL
L ISE
H ISE
LH ISE
Customer
L ISE
H ISE
LH
ISE
Broker Dealer
L ISE
H ISE
LH ISE
Proprietary

t+1
9.30
-6.96
3.01
13.71
-7.49
2.61
5.18
-4.90
2.56
9.01
-8.49
1.86

Cross-Sectional Returns BPS 2005 to 2012

t+2
t+3 t+4
t+5
t+10 t+20
t+30
17.92 10.78 10.65 3.20 1.43 -23.45 -67.29
-12.88 -1.89 0.01 4.68 12.84 32.58 69.77
5.82 12.49 13.58 12.14 14.11 8.22
9.04
14.95 12.99 20.36 11.68 23.67 5.84 -21.22
-8.37 5.34 11.07 17.18 40.79 75.55 134.42
10.63 15.56 17.62 22.43 28.62 55.55 117.04
19.29 8.62 13.66 10.25 4.76 -44.18 -109.48
-19.19 -5.19 -1.72 6.70 6.86 21.23 46.50
-3.03 2.73 6.91 12.78 10.09 -22.69 -57.61
19.52 10.74 -2.07 -12.32 -24.16 -32.01 -71.16
-11.07 -5.83 -9.31 -9.83 -9.14 0.95 28.39
6.26 10.55 -0.58 -12.10 -27.02 -33.64 -22.56

t+40
-61.87
93.79
9.04
-14.11
188.82
129.71
-82.12
59.33
-20.77
-89.39
33.23
-42.76

t+50
-69.05
130.10
25.05
-21.94
240.01
136.28
-95.95
98.31
-9.63
-89.26
51.99
-39.20

t+60
-69.05
157.61
25.05
-21.68
288.84
135.94
-120.54
118.77
-2.25
-103.51
65.21
-40.20

Looking closely at which strategy and trader experienced the strongest continuation effects out to
day 5, the customer traders with the mixture LH ISE strategy saw continuation out to day 5 with
22.42 bps in gains, with the majority of those gains added after next day. This seems to coincide
with a momentum effect and several studies show that information is not instantly absorbed into an
asset price but gradually diffuses over time. Hong et al. (1999) showed that two market participants,
newswatchers and momentum traders, attribute the most to diffusion of price information. This
delay provides momentum traders with a trade once news is injected into the marketplace
(Jegadeesh et al. 1993, Hong et al. 2000, Jegadeesh et al. 2001, Pan et al. 2006). Jegadeesh (1993)
16

showed reversals over months, and for this research, it is observed that significant reversal effects
are compressed to a much shorter time horizon, 5 days but also do align with prior research for
much longer terms as 60-day reversals seen across all strategies and traders, except for LH strategies
which showed mixed continuation and reversals effects.

Prior to the internet, information arrived to the masses more by word of mouth (Nazzaro et al.
2006), recently, information is deployed to the masses instantly via the web. What once trickled to
the entire investing community, is mostly available to the masses simultaneously. We are not
assuming all investor types are equally informed due to recent technological advances, however, it
can be conjectured that information gets absorbed quicker into assets prices through momentum
effects as the largest number of trades are attributable by the customer traders. In addition, looking
at the overall average cross-sectional returns, all strategies (average of all traders) experienced
reversals. The reversals appear to support past research which showed an over-reaction to news
(Barberis et al. 1998). Our signal was not directly derived off of a news event, like the
aforementioned research, but it has been shown that option volume does contain information about
future prices (Campbell et al. 1993, Easley et al. 1998, Cao et al. 2003, Pan et al. 2006 and Johnson
et al. 2012). It can be conjectured that high and low call-put ratios can be a product of informed
investors taking a larger position on one side, put or call. It appears as though the Customer trader
is able to take advantage of momentum effects in the very short-term, next day. The proprietary
trader exhibited the smallest next day gains, which aligns with the results of Pan et al. (2006) that
conjectured this trader was simply hedging and closing positions on the same day. The significant
continuation effect seen with the Customer trader LH strategy appears to be a result of underreaction as seen by Hong et al. (1999). As this strategy uses the top 4 and bottom 4 ratios, the cross
sectional returns were not the highest on day 1, rather by day 5 they outperformed all other
17

strategies. The information provided to the Customer trader to determine trades, was not fully
absorbed on event day, as can be seen with the continuation effects. This study supports this past
research through a significant financial crisis and recovery, however, we further break down the
momentum effects as they relate to specific traders and strategies based on a market data derived
signal, rather than a news event.

VIII. CONCLUSION
This paper shows that on a one day horizon stocks with low ISE values should be shorted,
conformist (aligns with original assumption), and stocks with high ISE values should also be
shorted, contrarian (does not align with original assumption). If the high ISE value signal was used
as a short signal, much higher gains would have been incurred. This aligns with much of the
aforementioned research studies that concluded several indicators (Bandopadhyaya et al. 2011,
Tsuji 2009 and Simon 2001, Lamont et al. 2004, Billingsley et al. 1988) are contrarian. Positive
alpha, for both the three-factor Fama-French and four-factor Carhart model, was seen across all
traders for the low ISE signal strategy which further reinforces the original assumption of shorting
stocks with a low ISE ratio.

The high ISE only is a contrarian indicator, short-term, next day, especially with the customer trader
derived call-put ratio, as it never had a positive Sharpe ratio. The latter experiment supports a
contrarian indicator for high value ISE stocks. The best performing trading signal, was the low ISE
only customer trader derived call-put ratio. This trading signal handily beat the SPY Sharpe ratio
and supports the assumption that L ISE value stocks to short are indeed conformist signals. The

18

combination of using low and high ISE valued stocks, was clearly weighed down by the contrarian
high ISE valued stocks.

Both strategies, L and H ISE, experienced significant reversal effects by day 60; the L signal going
against the original assumption and the H signal aligning with our original assumption of shorting
L and long H. In the long run, markets generally do go up, which surely explains a portion of these
long-term reversals.

These results do support that various call-put ratio strategies, derived from trader option volume,
specifically customer, are proxies of investor sentiment as we do see both significant reversal effects
when used in trading strategies. Future research will involve taking a close look at stocks whose
ISE values had significant sigma deviations away from expected ISE values. In addition, the
technical indicator derived from the ISE data will be combined with sentiment extracted from Social
Media to determine if the combination of the two features help explain price diffusion more than
any stand-alone version.

Acknowledgements
The authors thank Axel Vischer, Jeffrey Soule, and the International Securities Exchange
for providing the data and for discussing initial versions of this research and to the Howe School
Alliance for Technology Management for providing funds for this research. The authors also thank
Ionut Florescu, Hamed Ghoddusi, Jon Kaufman, David Starer, and participants of the High
Frequency data conference at Stevens Institute of Technology for suggestions and informal
discussions about this research. The opinions presented are the exclusive responsibility of the
authors.
19

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