Overcoming Arbitrage Limits: Option Trading and Momentum Returns

Abstract

We find that the decline in 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 options trading becomes expensive, the short position offers lower returns. We find that our results remain unchanged when we match the universe of stocks with and without options based on variables that determine the eligibility of a stock to be optionable, indicating that firm-level characteristics cannot account for the significant differences in the profitability of the two strategies.

Keywords: Momentum Returns, Stock Option Trading, Short-Sale Constraints

JEL Classification: G11, G12, G14, G32