Salience Theory and Option Returns

Abstract

In multiple asset classes, the pricing implications of salience theory on cross-sectional asset returns are clouded by informational overlaps with short-term past returns. Leveraging the directionless nature of the delta-hedged option returns, this paper documents the first unclouded evidence of salience theory's impact in the options market. We introduce a new option-based salience theory (OST) value and find its strong predictive power for cross-sectional option returns, which is not explained by past returns as observed in other asset classes. The option salience effect is stronger when investor sentiment is high, limits to arbitrage are elevated, and volatility is heightened.  

Keywords: Salience theory, equity option pricing, behavioral bias, investor attention

JEL Classification: G12, G13, G41