Are Options Redundant? The Benefits of Synthetic Diversification

Abstract

This paper examines an alternative avenue through which trading in options can expand investors' opportunity sets, unrelated to private information, differing opinions, endowments, or trading restrictions in the stock market. Investors can synthetically replicate the return profile of optionable stocks using options for a fraction of the cost of holding the underlying securities, which makes diversification more cost-efficient. We find that the option to stock volume ratio increases when stock price, idiosyncratic risk, stock illiquidity, borrowing cost, and market risk aversion are high. In addition, institutional holdings and option trading have a U-shaped relation.

Keywords: Asset pricing, Options markets, Portfolio diversification

JEL Classification: G11, G12