Price Pressures and Noise in Option Returns
51 Pages Posted: 4 Dec 2019 Last revised: 26 May 2020
Date Written: November 18, 2019
Delta-hedged option and straddle returns on S&P500 Index and equity options computed using end-of-day closing prices are biased upward. The bias can reach more than 100 bps per day and is attributed to overnight inventory risk. An introduction of SPX options night trading enables hedging of overnight positions and as a result, negative night and positive day option returns flip the signs. Liquidity providers’ ‘preferred’ inventory level, and the aversion to unbounded downside risk by options writers explain the results. Using intra-day, instead of closing prices helps explain several anomalies and establish identical volatility pricing across equity and index options.
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