Individual Investors and Market Efficiency in Derivative Markets: The KOSPI 200 Index Option Market Case Aug. 21, 2014 APAD 2014 Special Symposium Discussant: Young Ho Eom (Yonsei University)

Summary of Findings The Behavior of Individual Investors in the KOSPI 200 Index Options Market. Overall, foreign investors are net sellers, while domestic individual and institutional investors are net buyers. Domestic individual and institutional investors are trend followers (momentum investors) in terms of market direction. There is a positive relation between trade imbalances and prior implied volatility changes for individuals, but a negative relation for institutional investors. Individuals’ realized spread is the highest and foreign investors’ realized spread is the lowest. When individual investors buy (sell), the implied volatility moves up (down), but there is a large volatility reversal immediately after the trade. On the other hand, foreign investors buy (sell) options at low (high) implied volatility points, and implied volatility moves up (down) after the trade.

Summary of Findings Performance of Individual Investors in the KOSPI 200 Index Options Market. Individual investors consistently suffer a loss from options trading especially for short-term options and infrequent trades, while foreign investors make profits over the sample period especially from frequent trades. Individual investors make profits from trading DITM options and long-term options, while foreign investors make losses from trading DITM options and long-term options. The returns of managed portfolios that mimic the investment of investor groups show the same pattern after risk adjustment with Fama-French three factors, zero-beta straddle and variance premium. In terms of transaction price advantage, institutions have a price advantage for taking a long position, while foreign investors have a price advantage for taking a short position. Price disadvantage for individual investors is substantial for taking a short position of DOTM options.

Summary of Findings Price Discovery and Individual Investors. Overall, the foreigners have dominant power in explaining the variance of the efficient price.

Performance after Risk Adjustment Mimicking portfolio returns of individuals show positive beta to market factor and negative beta to volatility factor, while reverse is true for foreign investors. Why?

Performance after Risk Adjustment Straddles have large positive volatility betas. They allow investors to hedge volatility risk. If there is a risk premium for volatility risk, expected zero-beta straddle returns will be less than the risk free rate. According to Coval and Shumway (2001, JOF) a strategy of buying zero-beta straddles has an average return of around -3 percent per week. Ang, Hodrick, Xing and Zhang (2006, JOF) also show that returns of zero-beta straddle positions have a high correlation with changes in VIX and FVIX which mimics innovations in market portfolio volatility. Thus, individuals have a negative exposure to volatility factor. Similar explanation is possible for variance risk premium. A direct estimate of the average variance risk premium is the sample average of the difference between the realized variance and the variance swap rate. This difference measures the terminal profit and loss from a long variance swap contract and holding it to maturity. The average variance risk premium is negative because variance buyers are willing to accept a negative average return to hedge away upward movements in stock market volatility.

Option Positions Individual investors buy ATM options regardless of maturities. They tend to buy options with short-term maturities (<=20 days) and to sell options except ATM with long-term maturities. Foreign investors sell ATM options regardless of maturities. They tend to sell options with short-term maturities and to buy options except ATM with long-term maturities (> 30 days). Thus we would expect long in strangle like payoff for foreign investors. Foreigners may have long strangle like position to hedge volatility risk while paying variance risk premium. Note that foreigners make losses on trading long-term options.

Performance after Risk Adjustment Why do individuals, on average, make losses from option trading? Are KOSPI 200 options mis-priced? It is well known that writing put options seems to be profitable business in other markets (or put options are too expensive). If so, individuals may tend to buy over-priced options. Constantinides, Jackwerth and Savov (2013, RAPS) show that the alphas of short-maturity OTM puts become economically and statistically insignificant when any one of crisis-related factors incorporating price jumps, volatility jumps, and liquidity along with the market is incorporated in linear factor model. We may want to test whether the benchmark model of options returns cannot be rejected for option prices. Individual investors cannot easily pursue a strategy of writing options, because they have a limited access to capital. Santa-Clara and Saretto (2009, JFM) argue that margin requirements limit the notional amount of capital that can be invested in the strategies and force investors out of trades at the worst possible times. Thus, individuals may suffer losses due to forced liquidation.

Performance after Risk Adjustment Are foreign investors informed traders in KOSPI 200 option market? If so, why do they make losses from trading DITM options and long-term options? Choe, Kho, and Stulz (2005, RFS) show that foreign investors are at disadvantage relative to domestic investors and find no evidence that foreign investors are better informed in Korean stock market. They argue that disadvantage comes from their momentum trading behavior. It seems that individuals are momentum traders. Brennan and Cao (1997, JOF) show that it is optimal for less well-informed investors to chase returns. It is not clear how profits/losses are related to price advantage because foreign investors have advantage in trading DITM options but still make losses. If they are informed traders, they have to have advantage in both sides not just short position.

Performance after Risk Adjustment Who provides liquidity in KOSPI 200 option market? It seems to me that it is foreign investors that provides liquidity in the market because they are not directional traders, they make most of profits from frequent trading and their realized spread is the lowest. Foreign investors seem to make profits by providing liquidity for short- term options while performing risk-management (crash aversion) with long-term options. Garleanu, Pedersen and Poteshman (2009, RFS) argue that demand pressure causes option prices to be higher (market-makers charge a premium as compensation for incomplete hedge) than they would otherwise be in the presence of a more wide spread group of liquidity providers. Coupled with margin requirements and risk management concerns, profits of foreign investors may be partially explained by compensation for liquidity provisions.