Limited Attention and Option Prices

Abstract

We show that (partial) inattention to the underlying stock prices generates a demand pressure for options on low-priced stocks, resulting in overpricing of such options. Empirically, we find that delta-hedged options on low-priced stocks underperform those on high-priced stocks by 0.63% per week for calls and 0.36% for puts. Natural experiments corroborate this finding; options tend to become relatively more expensive following stock splits, and options on mini-indices are overpriced relative to options written on otherwise identical regular indices. Skewness preference does not explain our results.

Keywords: Option Returns, Investor Inattention

JEL Classification: G13, G14