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Differences in Trading and Pricing Between Stock and Index Options

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  • Michael Lemmon

    (David Eccles School of Business, University of Utah, Salt Lake City, Utah 84112)

  • Sophie Xiaoyan Ni

    (HKUST Business School, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong)

Abstract

We find that the demand for stock options that increases exposure to the underlying is positively related to the individual investor sentiments and past market returns, whereas the demand for index options is invariant to these factors. These differences in trading patterns are also reflected in the differences in the composition of traders with different types of options---options on stocks are actively traded by individual investors, whereas trades in index options are more often motivated by the hedging demand of sophisticated investors. Consistent with a demand-based view of option pricing, the individual investor sentiments and past market returns are related to time-series variations in the slope of the implied volatility smile of stock options, but they have little impact on the prices of index options. The pricing impact is more pronounced in options with a higher concentration of unsophisticated investors and those with higher delta hedging costs. Our results provide evidence that factors not related to fundamentals also impact security prices. This paper was accepted by Brad Barber, finance.

Suggested Citation

  • Michael Lemmon & Sophie Xiaoyan Ni, 2014. "Differences in Trading and Pricing Between Stock and Index Options," Management Science, INFORMS, vol. 60(8), pages 1985-2001, August.
    • Handle: RePEc:inm:ormnsc:v:60:y:2014:i:8:p:1985-2001
    DOI: 10.1287/mnsc.2013.1841
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    References listed on IDEAS

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