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Stock Market Efficiency and Price Predictions Implicit in Option Trading

Author

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  • R. L. Brown

    (Department of Accounting and Finance, Monash University. For helpful comments on earlier drafts we are grateful to Philip Brown, Graham Peirson, Richard Rendleman and participants in seminars at Monash University, the University of New South Wales and the University of Queensland. We are also grateful to Peter Small of the Options Clearing House (Sydney) for advice on certain details regarding data collection and to the Australian Merchant Bankers Association for providing us with interest rate data.)

  • T. J. Shevlin

    (Department of Accounting and Finance, Monash University. For helpful comments on earlier drafts we are grateful to Philip Brown, Graham Peirson, Richard Rendleman and participants in seminars at Monash University, the University of New South Wales and the University of Queensland. We are also grateful to Peter Small of the Options Clearing House (Sydney) for advice on certain details regarding data collection and to the Australian Merchant Bankers Association for providing us with interest rate data.)

Abstract

The Black-Scholes option pricing model (with approximate adjustments for dividends and exercise price changes) was used to generate stock prices which are “implied†by the model. If the stock market is efficient, these implied prices should not be capable of being used profitably by traders. This hypothesis is tested using prices established in the Australian Options Market and the Sydney Stock Exchange over the period February 1976 to December 1980. A close correspondence is found between implied stock prices and actual stock prices. Tests of the predictive power of the implied prices were unable to discover evidence of market inefficiency. However, a simulated trading strategy executed over one trading day and based on the largest discrepancies between actual and implied prices did meet with some success.

Suggested Citation

  • R. L. Brown & T. J. Shevlin, 1983. "Stock Market Efficiency and Price Predictions Implicit in Option Trading," Australian Journal of Management, Australian School of Business, vol. 8(2), pages 71-93, December.
    • Handle: RePEc:sae:ausman:v:8:y:1983:i:2:p:71-93
    DOI: 10.1177/031289628300800205
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    References listed on IDEAS

    as
    1. Manaster, Steven & Rendleman, Richard J, Jr, 1982. "Option Prices as Predictors of Equilibrium Stock Prices," Journal of Finance, American Finance Association, vol. 37(4), pages 1043-1057, September.
    2. Latane, Henry A & Rendleman, Richard J, Jr, 1976. "Standard Deviations of Stock Price Ratios Implied in Option Prices," Journal of Finance, American Finance Association, vol. 31(2), pages 369-381, May.
    3. Chiras, Donald P. & Manaster, Steven, 1978. "The information content of option prices and a test of market efficiency," Journal of Financial Economics, Elsevier, vol. 6(2-3), pages 213-234.
    4. Whaley, Robert E., 1981. "On the valuation of American call options on stocks with known dividends," Journal of Financial Economics, Elsevier, vol. 9(2), pages 207-211, June.
    5. MacBeth, James D & Merville, Larry J, 1979. "An Empirical Examination of the Black-Scholes Call Option Pricing Model," Journal of Finance, American Finance Association, vol. 34(5), pages 1173-1186, December.
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