Overcoming Arbitrage Limits: Option Trading and Momentum Returns

Abstract:

 with Abhay Abhyankar and Ilias Filippou 

We find that the decline in the momentum profitability is partly driven by option trading. Momentum profits arise from the short leg and therefore on barriers to short selling. We find strong evidence that the presence of stock options creates alternate avenues for short selling, augmenting the stock lending market, thus contributing to improved pricing efficiency. However, when option trading becomes expensive, the short position offers lower returns. We find that our results remain unchanged when we match the universe of stocks with and without options based on variables that determine the eligibility of a stock to be optionable indicating that firm-level characteristics cannot account for the significant differences in the profitability of the two strategies.

Presented at :

2021 AFA Annual Meeting (Chicago, US), Paris December 2019 Finance Meeting EUROFIDAI - ESSEC* (Paris, France), 2nd World Symposium on Investment Research 2019* (New York, US) , Eastern Finance Association 2019 (Miami, US), NOVA Business School (Lisbon, Portugal), SAEe 2018 (Madrid, Spain); NFA conference 2018 (Quebec, Canada) , Finance Forum 2018 (Santander, Spain)

Keywords: Momentum returns, stock option trading, short-sale constraints.

JEL Classification: G11, G12, G14, G32.

*Presented by co-authors.