Mutual Fund Hedging Demand and Individual Equity Option Returns

Abstract

I hypothesize that mutual fund ownership concentration, measured as the Herfindahl-Hirschman Index (HHI), in the underlying stock is positively correlated with stock holders' hedging demand for options on the corresponding stock. As for the stock with more concentrated ownership, some funds are more likely to overweight it and demand more of its options to hedge. Under the demand-based option pricing framework, market makers would charge higher option prices to absorb the order imbalance, which leads to lower subsequent option returns. Consistent with the demand-pressure channel, I find that HHI negatively predicts cross-sectional delta-hedged option returns. First, the predictability is driven by the funds that use protective put strategy to hedge the downside risk. Second, it is stronger among options with higher unhedgeable risks. Third, the effect takes places on puts rather than calls. Fourth, HHI cannot predict the underlying stock returns. Finally, transaction data reveals that institutional investors' demand is larger for puts written on the stocks with higher HHI. The findings cannot be reconciled with alternative explanations including short-selling costs and belief dispersions.

Keywords: Option return; Hedging.

JEL Classification: G13; G14; G23