Essays in Option Pricing

Abstract

This thesis consists of three standalone studies on option pricing. The first study explores the dynamics of idiosyncratic volatility in option returns over different horizons. We decompose stock idiosyncratic volatility into long-run and short-run components and find that both are negatively related to delta-hedged option returns. The effects of the long-run and short-run components are explained by the limits-of-arbitrage and stock return jumps, respectively. Unlike the long-run component, the short-run component can be used to create a trading strategy that remains profitable after considering transaction costs.

The second study explains the recent puzzle of option momentum from a behavioral perspective. Motivated by the frog-in-the-pan literature, we show that option momentum exists because investors are inattentive to past option return information that arrives continuously in small amounts. Our results reveal that option momentum strengthens in continuous information. Conversely, if past option returns are accumulated suddenly and dramatically, discrete information will attract investors’ attention and induce option price adjustment that eliminates option momentum. Our study also shows that continuous information can explain the persistence of option momentum over long horizons.

The third study documents novel co-movement patterns in option returns. We show that option returns co-move among firms linked by production complementarity, industry and shared analyst coverage. The co-movements in delta-neutral option returns can be explained by the option common factors. The stock market common factors, especially the market risk premium, can explain the co-movements in raw option returns but cannot explain the co-movements in delta-neutral returns. The co-movements in raw call returns intensify in bull markets, whereas the co-movements in raw put returns intensify in bear markets. There are also peer option momentum effects among economically linked firms.