Does Option Trading Impact Underlying Stock Prices

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Does Option Trading Have a Pervasive Impact on Underlying Stock Prices? … substantial and pervasive influence of option trading on stock prices. …

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Does Option Trading Have a Pervasive Impact on Underlying Stock Prices?*
Neil D. Pearson
University of Illinois at Urbana-Champaign
Allen M. Poteshman
University of Illinois at Urbana-Champaign
Joshua White
University of Illinois at Urbana-Champaign
July 31, 2006
**Preliminary and Incomplete: Please do not quote or circulate.
* Department of Finance, College of Business, University of Illinois at Urbana-Champaign, 340 Wohlers Hall, 1206 South Sixth Street, Champaign, IL 61820 (Phone: (217) 244-0490, e-mail: pearson2@uiuc.edu; phone: (217) 265-0565, e-mail: poteshma@uiuc.edu; and phone: (217) 244-1166, email: jswhite@uiuc.edu.) We thank Joe Levin, Eileen Smith, and Dick Thaler for assistance with the data used in this paper. Qian Deng provided excellent research assistance. We bear full responsibility for any remaining errors.Does Option Trading Have a Pervasive Impact on Underlying Stock Prices?
ABSTRACT
The question of whether and to what extent option trading impacts underlying stock prices has been a focus of intense interest since options began exchange-based trading in 1973. Despite considerable effort, no convincing evidence for a pervasive impact has been produced. A recent strand of theoretical literature predicts that rebalancing by traders who hedge their option positions increases (decreases) underlying stock return volatility when these traders have net written (purchased) option positions. This paper tests this prediction and finds a statistically and economically significant negative relationship between stock return volatility and net purchased option positions of investors who are likely to hedge. Hence, we provide the first evidence for a substantial and pervasive influence of option trading on stock prices….