Option Mispricing around Nontrading Periods

• DOI: http://doi.org/10.1111/jofi.12603
• Author: CHRISTOPHER S. JONES,JOSHUA SHEMESH
• Date: 01 April 2018
• Published date: 01 April 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 2 •APRIL 2018

Option Mispricing around Nontrading Periods

CHRISTOPHER S. JONES and JOSHUA SHEMESH∗

ABSTRACT

We find that option returns are significantly lower over nontrading periods, the vast

majority of which are weekends. Our evidence suggests that nontrading returns can-

not be explained by risk, but rather are the result of widespread and highly persistent

option mispricing driven by the incorrect treatment of stock return variance during

periods of market closure. The size of the effect implies that the broad spectrum of

finance research involving option prices should account for nontrading effects. Our

study further suggests how alternative industry practices could improve the efficiency

of option markets in a meaningful way.

AVARIETY OF INSTITUTIONAL and psychological factors suggest that portfolio risk

and return may differ between periods of trading and nontrading. The stock

market is more volatile over trading periods than over nontrading periods,

possibly due to a lower rate of private information revelation (French and Roll

(1986)). It is also profoundly less liquid outside of regular trading hours, which

should drive a wedge between average returns over trading and nontrading

periods (French (1980), Longstaff (1995), Kelly and Clark (2011), Cliff, Cooper,

and Gulen (2008)). Prolonged periods of nontrading may also give investors

with limited attention a chance to process stale information, whether contained

in firm earnings announcements (Dellavigna and Pollet (2009)) or news more

generally (Garcia (2013)). Finally, traders may have a strong desire to exit the

market over nontrading periods, with no open positions, particularly for more

speculative strategies or for longer periods of nontrading (Hendershott and

Seasholes (2006)).

∗Christopher S. Jones is with the Marshall School of Business at the University of Southern

California. Joshua Shemesh is with the Department of Banking and Finance at the Monash

Business School. We are grateful for comments from Editors Cam Harvey and Ken Singleton,

two anonymous referees, Mike Chernov, Dan Galai, Bruce Grundy, Larry Harris, Robert Hudson,

Blair Hull, Nikunj Kapadia, Spencer Martin, Dmitriy Muravyev,Yigal Newman, Oguz Ozbas, Nick

Polson, Allen Poteshman, Eric Renault, David Solomon, Selale Tuzel, Mark Weinstein, Fernando

Zapatero, and seminar participants at USC, the University of Queensland, Hebrew University,the

2009 Montreal Financial Econometrics Conference, the 2009 Financial Management Association

meetings, and the 2010 American Finance Association meetings. Most of the research was done

while Shemesh was affiliated with the University of Melbourne. Shemesh thanks the Sanger Chair

of Banking and Risk Management for financial support. Both authors state that their work on this

research was not supported financially by any nonacademic sources and that no organization or

individual has had any right to review this work.

DOI: 10.1111/jofi.12603

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862 The Journal of Finance R

While the above effects have been documented to varying degrees in the

market for individual stocks or stock indexes, one might expect most if not

all to be more pronounced in the market for options. Predictable differences

in volatility should have first-order effects on option prices (see also Dubinsky

and Johannes (2006)), while varying liquidity should affect not only the option

end user but also the market maker who must delta-hedge his underlying

exposure in the stock market (e.g., Cetin et al. (2006)). Limited attention may

be more problematic in option markets, where small changes in fundamentals

can have large valuation effects. Finally, option trades can be extremely risky,

particularly for net written option positions, pushing some traders to withdraw

completely during overnight or weekend periods.

Among these effects, it is the desire to close positions over the weekend that

Chen and Singal (2003) conclude was responsible for the weekend effect in

stocks. The weekend effect, or the tendency of stock returns to be low over the

weekend, is perhaps the most widely documented nontrading effect (French

(1980)). Though evidence of the effect goes back to the early 1900s (Fields

(1931)), authors such as Connolly (1989) and Chang, Pinegar, and Ravichan-

dran (1993) show that it started to dissipate in the 1970s or 1980s. Chen

and Singal (2003) hypothesize that the desire to close positions before the

weekend would be most pronounced for short sellers who were deterred by

the unbounded downside risk inherent in their positions. When option mar-

kets opened in the 1970s and 1980s, these investors were able to take bearish

positions with limited downside risk or hedge downside risk over nontrad-

ing periods using options. Consistent with their hypothesis, Chen and Singal

(2003) show that the introduction of options on a firm’s stock coincides with the

elimination of the weekend effect for that firm.

Writing options also exposes a trader to unbounded downside risk, particu-

larly over nontrading periods. For call options, this comes from the potentially

infinite positive payoff that accrues to the option buyer as the stock price rises.

While delta-hedging reduces this exposure, the inability to perfectly hedge due

to transactions costs, price discontinuities, and nontrading periods means that

this downside risk cannot be eliminated. That is, a call writer can experience

an arbitrarily large loss if the stock price rises high enough before the hedge

can be rebalanced. When writing put options, downside risk is bounded but

often extremely large, since the maximum payoff (which occurs when the stock

price drops to zero) can be orders of magnitude greater than the option’s price.

Paradoxically, delta-hedging a put causes this downside to become unbounded,

since hedging requires taking a short position in the stock, which itself is

unbounded.

Given the above discussion, if investors are generally averse to holding posi-

tions with extreme downside risk over the weekend, option writers may have

an incentive to cover their positions by Friday close. While this should have no

effect in a Black and Scholes (1973) world in which options can be replicated via

continuous trading, Bollen and Whaley (2004) show empirically that demand

pressure does, in fact, have a substantial impact on option prices. Garleanu,

Pedersen, and Poteshman (2009) add to this evidence and show theoretically

Option Mispricing around Nontrading Periods 863

that the effect is likely driven by the inability to perfectly replicate. Since cover-

ing net written option positions can be regarded as positive demand pressure,

any tendency to do so prior to Friday close should lead to temporarily higher

option prices that return to normal by the following Monday.

Alternatively, those same investors should be willing to keep their short po-

sitions open given some additional compensation for the substantial downside

risk they face. Since compensation to option writers comes in the form of nega-

tive option returns, this argument suggests that we should also see a weekend

effect in call and put options, with weekend option returns being significantly

lower than returns over the rest of the week.

Using a large sample of daily returns on equity options over the period from

January 1996 to August 2014, we investigate nontrading effects in the equity

option market. We find pervasive, large, and highly statistically significant ev-

idence that nontrading returns on options are lower than trading returns. We

focus on average returns on delta-neutral positions, which are highly negative

over periods of nontrading (i.e., weekends and midweek holidays), but essen-

tially zero on average on other days. There is no evidence of any nontrading

effect in underlying stock returns in our sample.

We find strong effects in puts and callsand across almost all levels of maturity

and moneyness, with the results robust to different sampling methods and

weighting schemes. The nontrading effect is negative in each year of our 19-

year sample and is statistically significant in most. We also find strong evidence

of a nontrading effect in S&P 500 Index puts and weaker evidence of nontrading

effects in S&P 500 Index calls. We find significant nontrading effects for regular

weekends, long weekends, and midweek holidays.

Nontrading effects are also evident in implied volatilities. As noted by French

and Roll (1986), the variance of the return over a weekend (Friday close to

Monday close) is just slightly greater than the variance over a regular weekday,

implying little variance during periods of market closure. However, implied

volatilities seem to embed the expectation that stock price variance will remain

sizable even when the market is closed. This discrepancy is large and significant

for both equity options and S&P 500 Index options.

We explore three possible explanations for these findings. The first is that

nontrading returns are lower because of differential levels of risk between

trading and nontrading periods. The second is that aversion to unbounded

downside risk rises over nontrading periods, as hypothesized by Chen and

Singal (2003). Since this risk is experienced by option writers but not buyers,

option writers will require a higher risk premium to keep positions open. Since

writers are short options, this means that option returns must be negative over

the weekend. The third explanation we consider is that the nontrading effect

is the result of widespread and highly persistent market mispricing.

We find that portfolios of delta-neutral positions do show somewhat greater

risk over nontrading periods relative to trading periods. For puts, the effect

is modest: the put portfolio’s standard deviation is about 10% higher over

nontrading periods (mostly weekends) than it is over regular trading intervals,

and there is no significant change in return skewness or kurtosis. In contrast,