Underreaction, Overreaction, and Increasing Misreaction to Information in the Options Market

48 Pages Posted: 25 Mar 2001

See all articles by Allen M. Poteshman

Allen M. Poteshman

University of Illinois at Urbana-Champaign - Department of Finance

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Abstract

This paper investigates options market reaction to changes in the instantaneous variance of the underlying asset. There are three main findings. First, options market investors underreact to individual daily changes in instantaneous variance. Second, these same investors overreact to periods of mostly increasing or mostly decreasing daily changes in instantaneous variance. Third, they tend to underreact (overreact) to current daily changes in instantaneous variance that are preceded mostly by daily changes of the opposite (same) sign. The third finding can reconcile the first two and is also consistent with well-established cognitive biases.

Keywords: Misreaction, Behavioral Finance, Option Pricing, Stochastic Variance

Suggested Citation

Poteshman, Allen M., Underreaction, Overreaction, and Increasing Misreaction to Information in the Options Market. Available at SSRN: https://ssrn.com/abstract=262018 or http://dx.doi.org/10.2139/ssrn.262018

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