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Informed Option Trading and Stock Market Mispricing

49 Pages Posted: 7 Aug 2010 Last revised: 28 Jun 2011

Redouane Elkamhi

University of Toronto - Rotman School of Management

Yong Lee

McGill University - Desautels Faculty of Management

Tong Yao

University of Iowa - Henry B. Tippie College of Business

Date Written: 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.

Keywords: informed option trading, idiosyncratic volatility anomaly

Suggested Citation

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

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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 )

Acquisitions
5020 Main Library
Iowa City, IA 52242-1000
United States

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