Abstract

http://ssrn.com/abstract=1654138
 
 

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Informed Option Trading and Stock Market Mispricing


Redouane Elkamhi


University of Iowa - Henry B. Tippie College of Business

Yong Lee


McGill University - Desautels Faculty of Management

Tong Yao


University of Iowa - Henry B. Tippie College of Business

June 27, 2011


Abstract:     
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

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Date posted: August 7, 2010 ; Last revised: June 28, 2011

Suggested Citation

Elkamhi, Redouane and Lee, Yong and Yao, Tong, Informed Option Trading and Stock Market Mispricing (June 27, 2011). Available at SSRN: http://ssrn.com/abstract=1654138 or http://dx.doi.org/10.2139/ssrn.1654138

Contact Information

Redouane Elkamhi
University of Iowa - Henry B. Tippie College of Business ( email )
108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States
Yong Lee
McGill University - Desautels Faculty of Management ( email )
1001 Sherbrooke St. West
Montreal, Quebec H3A1G5
Canada
+1-514-398-4000 (0231) (Phone)
Tong Yao (Contact Author)
University of Iowa - Henry B. Tippie College of Business ( email )
108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States
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