Margin Requirements and Equity Option Returns

Abstract

In equity option markets, traders face margin requirements both for the options themselves and for hedging-related positions in the underlying stock market. We show that these requirements carry a significant margin premium in the cross-section of equity option returns. The sign of the margin premium depends on the option's expensiveness: Option returns decrease with margins for expensive options, while they increase for cheap options. Our results are statistically and economically significant and robust to different margin specifications and various control variables. We explain our findings by a model of funding-constrained derivatives dealers who require compensation for satisfying end-users' option demand.

Keywords: equity options, margins, funding liquidity, cross-section of option returns

JEL Classification: G12, G13