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On the Causal Effect of Option Trading on Underlying Stock Pricing

35 Pages Posted: 28 Mar 2015  

Tong Wang

Virginia Polytechnic Institute & State University - Department of Finance, Insurance, and Business Law

Date Written: February 7, 2015

Abstract

This paper shows that option trading does not reduce overpricing in the underlying stock market. A popular view in the literature is that options lower short selling cost, therefore, they allow stock prices to better incorporate negative information and opinions. Testing such a hypothesis is challenging because certain variables can drive both option trading and stock pricing, and failure to control for these variables gives rise to endogeneity issues. We develop an instrumental variable for option trading volume and use it to show that exogenous increase in option trading leads to more severe overpricing, which contradicts the existing view. Specifically, the instrumental variable is the distance between two adjacent option strike prices measured as a percentage of the underlying stock price.

Keywords: options, stocks, overpricing, strike price

JEL Classification: G12,G13,G14

Suggested Citation

Wang, Tong, On the Causal Effect of Option Trading on Underlying Stock Pricing (February 7, 2015). Available at SSRN: https://ssrn.com/abstract=2585680 or http://dx.doi.org/10.2139/ssrn.2585680

Tong Wang (Contact Author)

Virginia Polytechnic Institute & State University - Department of Finance, Insurance, and Business Law ( email )

1016 Pamplin Hall (0221)
Blacksburg, VA 24060-0221
United States

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