Are Options Redundant? The Benefits of Synthetic Diversification

49 Pages Posted: 9 Jun 2019 Last revised: 24 Jul 2019

See all articles by Yifan Liu

Yifan Liu

Oklahoma State University - Stillwater - Department of Finance

Louis R. Piccotti

Oklahoma State University - Stillwater - Spears School of Business

Date Written: July 23, 2019

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

Suggested Citation

Liu, Yifan and Piccotti, Louis R., Are Options Redundant? The Benefits of Synthetic Diversification (July 23, 2019). Available at SSRN: https://ssrn.com/abstract=3392421 or http://dx.doi.org/10.2139/ssrn.3392421

Yifan Liu (Contact Author)

Oklahoma State University - Stillwater - Department of Finance ( email )

Spears School of Business
Stillwater, OK 74078-4011
United States

Louis R. Piccotti

Oklahoma State University - Stillwater - Spears School of Business ( email )

460 Business
Stillwater, OK 74078-0555
United States

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