Overcoming Arbitrage Limits: Option Trading and Momentum Returns
84 Pages Posted: 24 Jul 2018 Last revised: 29 May 2020
Date Written: January 27, 2019
In this paper we find that the decline in the momentum profitability is partly driven by option trading. Momentum profits arise from the short leg and therefore on barriers to short selling. We find strong evidence that the presence of stock options creates alternate avenues for short selling, augmenting the stock lending market, thus contributing to improved pricing efficiency. However, when option trading becomes expensive, there are more barriers to short selling and the short position offers lower returns. Our results are robust to exogenous changes in short selling due to Regulation SHO and are supported by other short-leg depended anomalies.
Keywords: Momentum Returns, Stock Option Trading, Short-Sale Constraints
JEL Classification: G11, G12, G14, G32
Suggested Citation: Suggested Citation