Does Option Trading Have a Pervasive Impact on Underlying Stock Prices?

47 Pages Posted: 16 Mar 2007

See all articles by Neil D. Pearson

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance; Canadian Derivatives Institute

Allen M. Poteshman

University of Illinois at Urbana-Champaign - Department of Finance

Joshua S. White

University of Illinois at Urbana-Champaign - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: February 23, 2007

Abstract

The question of whether and to what extent option trading impacts underlying stock prices has been a focus of intense interest since options began exchange-based trading in 1973. Despite considerable effort, no convincing evidence for a pervasive impact has been produced. A recent strand of theoretical literature predicts that rebalancing by traders who hedge their option positions increases (decreases) underlying stock return volatility when these traders have net written (purchased) option positions. This paper tests this prediction and finds a statistically and economically significant negative relationship between stock return volatility and net purchased option positions of investors who are likely to hedge. Hence, we provide the first evidence for a substantial and pervasive influence of option trading on stock prices.

Keywords: options, stock price paths, impact, trading, hedging

JEL Classification: G10, G12

Suggested Citation

Pearson, Neil D. and Poteshman, Allen M. and White, Joshua S., Does Option Trading Have a Pervasive Impact on Underlying Stock Prices? (February 23, 2007). AFA 2008 New Orleans Meetings Paper, Available at SSRN: https://ssrn.com/abstract=970592 or http://dx.doi.org/10.2139/ssrn.970592

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0490 (Phone)
217-244-9867 (Fax)

Canadian Derivatives Institute ( email )

3000, chemin de la Côte-Sainte-Catherine
Montréal, Québec H3T 2A7
Canada

Allen M. Poteshman (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

340 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
United States
217-265-0565 (Phone)
217-244-3102 (Fax)

HOME PAGE: http://www.business.uiuc.edu/poteshma

Joshua S. White

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
(217) 244-1166 (Phone)

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