Can Options Volume Predict Market Returns?

Key Takeaways

• In‑the‑money options order imbalance predicts returns up to three months
• Predictive power strengthens during recessionary periods
• Public customers’ demand drives sentiment signal, not proprietary traders
• Signal persists after controlling for VIX, VRP, PE, macro variables
• Institutional investors may make suboptimal directional bets

Summary

A recent study examines the order imbalance of in‑the‑money S&P 500 options placed by public customers and finds it predicts market returns over a one‑ to three‑month horizon, extending up to nine months in some tests. The directional order imbalance (DOI) shows a strong negative correlation with future returns, especially during recessionary periods. The research controls for traditional predictors such as VIX, volatility risk premium, PE ratios, and macro‑uncertainty measures, confirming the robustness of the signal. It also highlights that less‑sophisticated institutional investors may make suboptimal directional bets.

Pulse Analysis

While most academic work on equity options concentrates on volatility and the volatility risk premium, the trading volume of in‑the‑money (ITM) contracts has received far less attention. Recent research isolates the order imbalance of ITM S&P 500 options placed by public customers—mutual funds, pension plans, and other non‑proprietary traders—to capture a pure sentiment signal. Because ITM options are largely insensitive to the VIX, their imbalance reflects directional bets rather than pure volatility exposure, offering a clearer window into how less‑sophisticated institutions view market direction.

The study finds that this directional order imbalance (DOI) predicts S&P 500 returns over a one‑ to three‑month horizon, with the signal extending to nine months in some specifications. The negative relationship—higher public demand for ITM calls coincides with lower future returns—remains significant after controlling for traditional predictors such as the VIX, volatility risk premium, price‑to‑earnings ratios, and macro‑uncertainty indices. Notably, the predictive strength intensifies during recessionary periods, suggesting that limits to arbitrage and heightened risk aversion amplify the sentiment captured by public ITM trades.

For portfolio managers, DOI offers a low‑cost, data‑driven gauge of collective institutional bias that can complement existing factor models. Incorporating the signal into tactical asset allocation or risk‑adjusted timing strategies may improve downside protection, especially when macro conditions signal a downturn. However, the edge is modest and likely erodes as more market participants adopt the metric, underscoring the importance of continuous monitoring and integration with broader sentiment and macro frameworks. Moreover, the signal's focus on public customers helps differentiate it from proprietary trading noise, making it particularly valuable for investors seeking contrarian cues.