Do investors follow the herd in option markets?

Abstract

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Option‐implied information and stock herding

“…Previous studies have documented a more pronounced tendency for herding during crises (Bernales, Verousis, & Voukelatos, 2016;Chiang & Zheng, 2010), suggesting that investors tend to focus on the market consensus substantially more during turbulent times. Previous studies have documented a more pronounced tendency for herding during crises (Bernales, Verousis, & Voukelatos, 2016;Chiang & Zheng, 2010), suggesting that investors tend to focus on the market consensus substantially more during turbulent times.…”

“…1006 Third, we examine if the timing of U.S. macroeconomic announcements has an impact on the cross-sectional dispersion of stock returns, potentially by subsuming the informational content of the option-related variables. More importantly, macroeconomic announcements have been previously shown to be related to herding effects in stocks (Galariotis, Rong, & Spyrou, 2015) and options (Bernales, Verousis, & Voukelatos, 2016). More importantly, macroeconomic announcements have been previously shown to be related to herding effects in stocks (Galariotis, Rong, & Spyrou, 2015) and options (Bernales, Verousis, & Voukelatos, 2016).…”

“…Given that the returns of risk reversals are driven by changes in the tails of the implied volatility smirk (and, by extension, by changes in investors' expectations about the tails of the index's distribution), these strategies are often used as proxies for skewness risk (Bakshi et al, 2008;Bernales, Verousis, & Voukelatos, 2016). On each day, we identify a deep OTM index put and a deep OTM index call (with absolute deltas of 0.125).…”

What do we know about individual equity options?

“…In a more recent study, Bernales et al () find the evidence of herding behavior in the US equity option market, with investors suppressing their own beliefs in favor of the market consensus, during periods of market stress. This herding behavior is reflected in investors being heavily influenced by the contemporaneous returns of index options when they are pricing individual stock options, resulting in a price clustering that reduces the ability to hedge positions efficiently.…”

“…Europe 2009-2010 Reducing the tick size resulted in smaller spreads but lower depths Anand, Hua, and McCormick (2016) US 2007-2013 A make-take structure increases quote competition among market makers, reducing execution costs Panel C: Investor behavior departing from rationality Poteshman and Serbin (2003) US 1996-1999 Evidence of irrational early exercise of American-style options Hao, Kalay, and Mayhew (2010) US 2003 Option investors regularly fail to exercise options rationally before exdividend dates Lemmon and Ni (2014) US 1990-2010 The demand for individual equity options that increases exposure to the underlying is positively related to the individual investor sentiment and past market returns Bernales, Verousis, and Voukelatos (2016) US 1996-2012 Option investors herd around the consensus during periods of market stress Wei and Zheng (2010) find evidence that the bid-ask spread is affected by maturity substitution and moneyness substitution in option trading, with these effects driven by expiration cycles and stock return volatility. Examining a large sample of options written on US stocks, Wei and Zheng (2010) show that, due to the structure of the expiration cycles in the option market, demand shifts predictably from medium-to short-term options when the third expiration month is too far away.…”