Differences in Trading and Pricing between Stock and Index Options

32 Pages Posted: 9 May 2014

See all articles by Michael Lemmon

Michael Lemmon

University of Utah - Department of Finance

Sophie Xiaoyan Ni

Hong Kong Baptist University (HKBU)

Date Written: May 7, 2013

Abstract

We find that the demand for stock options that increases exposure to the underlying is positively related to the individual investor sentiments and past market returns, whereas the demand for index options is invariant to these factors. These differences in trading patterns are also reflected in the differences in the composition of traders with different types of options — options on stocks are actively traded by individual investors, whereas trades in index options are more often motivated by the hedging demand of sophisticated investors. Consistent with a demand-based view of option pricing, the individual investor sentiments and past market returns are related to time-series variations in the slope of the implied volatility smile of stock options, but have little impact on the prices of index options. The pricing impact is more pronounced in options with a higher concentration of unsophisticated investors and those with higher delta hedging costs. Our results provide evidence that factors not related to fundamentals also impact security prices.

Keywords: Options, Volatility Smile, Sentiment, Speculation, Behavior

JEL Classification: G1, G12, G13

Suggested Citation

Lemmon, Michael and Ni, Sophie Xiaoyan, Differences in Trading and Pricing between Stock and Index Options (May 7, 2013). Available at SSRN: https://ssrn.com/abstract=2434340 or http://dx.doi.org/10.2139/ssrn.2434340

Michael Lemmon

University of Utah - Department of Finance ( email )

David Eccles School of Business
Salt Lake City, UT 84112
United States

Sophie Xiaoyan Ni (Contact Author)

Hong Kong Baptist University (HKBU) ( email )

Kowloon
Hong Kong

HOME PAGE: http://sites.google.com/site/sophiexni/

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