Informed Option Trading and Stock Market Mispricing
49 Pages Posted: 7 Aug 2010 Last revised: 28 Jun 2011
Date Written: June 27, 2011
Despite the theoretical prediction that options improve market efficiency, this study finds that option trading does not attenuate the well-known idiosyncratic volatility anomaly, i.e., the negative relation between idiosyncratic volatility and subsequent stock returns. We argue that the relation between informed option trading and the magnitude of the anomaly is driven by two effects: participation by informed investors improves market efficiency (a causality effect), but their option trades are likely to occur on most inefficiently priced stocks (a selection effect). Using two proxies for informed option trading, we show that the selection effect dominates. Among stocks with high informed option trading intensity, a long-short portfolio based on idiosyncratic volatility deciles generates returns as high as 2.11% per month. By contrast, for stocks with low informed option trading intensity, idiosyncratic volatility does not predict stock returns. We also find that the private information possessed by option traders is related to forthcoming corporate earnings news.
Keywords: informed option trading, idiosyncratic volatility anomaly
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