How Does Stock Illiquidity Affect the Informational Role of Option Prices?
67 Pages Posted: 9 Aug 2016 Last revised: 4 May 2018
Date Written: April 26, 2018
We argue that deviations from put-call parity can predict stock returns for mechanical reasons unrelated to informed option trading. Theoretically, in the presence of stock trading costs, it is more (less) expensive to replicate call options relative to put options when the price of the underlying stock is more likely to increase (decrease). Empirically, we identify this mechanism by separating the actions of hedgers and speculators using an exogenous short-sale prohibition with a limited exemption for option dealers. We use equity lending fees to proxy for option replication costs, and option order-flow imbalances to rule out the informed trading explanation.
Keywords: Put-Call Parity, Stock Return Predictability, Option Replication, Short-Selling
JEL Classification: G11, G12, C13
Suggested Citation: Suggested Citation