Index volatility and the put-call ratio: a tale of three markets

Abstract

This paper investigates the influence of the put-call-ratio (PCR) implied by the Shanghai Stock Exchange (SSE) 50 ETF option on the price discovery process of the SSE50 index, on both the spot and the futures markets. By constructing an asymmetric VARX-MGARCH model, this paper examines the relationship between the PCRs and SSE50 index (futures). Empirical results indicate an asymmetric V-shaped relationship between the PCRs and the conditional volatility of the stock index returns and the index futures returns. The conditional volatility increases as the PCRs deviate widely from the mean. This study suggests that the PCRs implemented in many trading practices may be misused, because there is no evidence that the PCRs and index returns are correlated. Instead, this research implies a different way of using them: to trade volatility.

Keywords:

• SSE50-ETF
• Futures
• Option
• PCR
• MGARCH

JEL Classification:

• E32
• G11
• G14
• G15

Acknowledgements

The authors appreciate kind help from our research assistants, Mr Yunhan Guo from Renmin University of China, and Ms Yu Xia from Columbia University.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Statistics are shown in Table 1.

2 Gang et al. (2019) also investigate the predictability of the 50ETF option.

3 Huaxia Fund Management Co., Ltd., which is the only manager of the SSE50-ETF, is obligated to compile and update these guidelines.

4 The CSI300 and CSI500 indices are capitalization-weighted stock market indices designed to replicate the performance of major stocks traded on the Shanghai and Shenzhen stock exchanges. Tickers for CSI 300, CSI 500, and SSE50 index futures are IF, IC, and IH, respectively.

5 The Wind financial database (http://www.wind.com.cn/) is the largest vendor of professional financial data and information on Chinese stocks, bonds, funds, futures, RMB rates, and the macroeconomy.

6 The start date is the day on which the SSE50-ETF option was officially introduced to the market.

7 This is, however, different from the evidence from developed markets (Bollen and Whaley 2004).

8 In addition, the prediction power has also been tested for longer horizons up to 20 days (τ = 1,2, … , 20). The PCR is insignificant at any τ. Results can be obtained by request.

9 The lag order of VAR is determined based on the BIC.

10 Nyberg (2013) shows that the average period of bull market is 37.17 months and the average period of bear market is 14.08 months in the US, while the corresponding counterparts in China are 15.25 and 14.14 months, respectively. Liu and Wang (2017) also find the Chinese stock market has ‘crazy bull’ and ‘frequent and quick bear’.

11 There is another reason for the index option to be even less used to hedge the downside risk: the index futures market in China has a much longer trading history (since April 2010), therefore it has a much larger trading volume (62.7 billion yuan of all index futures and 1.02 million yuan of index options as of the date on 28 September 2018), more tradable underlying indices (including SSE50), and is more widely participated. Hence, the index futures contracts are much often used for hedging than index options.

12 During the market crash, there are many critics of the role of index futures arguing that the index futures market serves as a venue of speculative trading and exacerbates the spot market volatility. Therefore, the China Financial Futures Exchange (CFFEX) announced on August 25 that starting August 26, three measures would be adopted to curb speculative trading in the index futures market. First, the initial margin for non-hedging trades would be raised from 10% to 12%, 15%, and finally 40% over the following two weeks. Second, any single day non-hedging trading of over 10 contracts would be considered abnormal trade and be subject to scrutiny. Third, the clearing fees for intraday trades would be adjusted upward to 1.15 (soon adjusted to 23) basis points. With these drastic measures, the index futures trading in China nearly came to a complete stop (Han and Liang 2017).