Informed Option Trading and Stock Market Mispricing
University of Toronto - Rotman School of Management
McGill University - Desautels Faculty of Management
University of Iowa - Henry B. Tippie College of Business
June 27, 2011
Despite the theoretical prediction that options improve market efficiency, this study finds that option trading does not attenuate the well-known idiosyncratic volatility anomaly, i.e., the negative relation between idiosyncratic volatility and subsequent stock returns. We argue that the relation between informed option trading and the magnitude of the anomaly is driven by two effects: participation by informed investors improves market efficiency (a causality effect), but their option trades are likely to occur on most inefficiently priced stocks (a selection effect). Using two proxies for informed option trading, we show that the selection effect dominates. Among stocks with high informed option trading intensity, a long-short portfolio based on idiosyncratic volatility deciles generates returns as high as 2.11% per month. By contrast, for stocks with low informed option trading intensity, idiosyncratic volatility does not predict stock returns. We also find that the private information possessed by option traders is related to forthcoming corporate earnings news.
Number of Pages in PDF File: 49
Keywords: informed option trading, idiosyncratic volatility anomaly
Date posted: August 7, 2010 ; Last revised: June 28, 2011
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