Embedded Leverage and Gambling Preferences

Abstract:

 with Ilias Filippou and Fernando Zapatero.

In this paper we examine the role of option trading in strategies with lottery-like payoffs. Specifically, we examine the substitution between equities with high past skewness or past daily maximum returns (i.e. lottery stocks) and options with high moneyness or high ex-ante skewness (i.e. lottery options). We find that lottery stocks tend to provide insignificant returns due to the increasing role of lottery option trading. Consistently with theoretical information-based models, we show that embedded leverage (main determinant of option trading volume) is the driver of this phenomenon as investors tend to substitute lottery options with lottery stocks when the moneyness, implied volatility and stock illiquidity are high.

Presented at :

University of Lugano* 2016, University of Exeter 2016

*Presented by co-authors.

Keywords: Lottery-payoffs, Option Trading, lottery stocks.

JEL Classification: G11, G12, G14, G32.

Working Papers