Overconfidence Among Option Traders

Abstract

The investor overconfidence theory predicts a direct relationship between market-wide turnover and lagged market return. Whereas previous research has examined this prediction in the equity market, we focus on trading in the options market. Controlling for stock market cross-sectional volatility, stock idiosyncratic risk, and option market volatility, we find that option trading turnover is positively related to past stock market return. In addition, call option turnover and call to put ratio are also positively associated with the past stock market return. These findings are consistent with the overconfidence theory. We also find that overconfident investors trade more in the options market than in the equity market. We rule out explanations other than investor overconfidence, such as momentum trading and varying risk preferences, for our findings.

Keywords: Overconfidence, Options market, Trading volume, Behavioral finance

JEL Classification: G02, G10