Overconfidence among option traders

• Date: 01 January 2019
• DOI: http://doi.org/10.1002/rfe.1048
• Author: Han‐Sheng Chen,Sanjiv Sabherwal
• Published date: 01 January 2019

Rev Financ Econ. 2019;37:61–91. wileyonlinelibrary.com/journal/rfe

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© 2019 University of New Orleans

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INTRODUCTION

In recent years, trading activities in both equity and options markets have been noticeably intense. The heavy trading in these

markets raises the question as to what inspires investors to trade. An understanding of the reasons for trading is of interest,

not only because of heavy trading in both equity and options markets, but also because of the higher volatility associated with

greater trading volume. The volatility in the equity market has received substantial attention from financial scholars since

Shiller (1981) and LeRoy and Porter (1981) pointed out the phenomenon.

To partially answer the question why investors trade, Statman, Thorley, and Vorkink (2006) follow the stream of literature

in the overconfidence theory1 and present empirical evidence in the equity market that supports the theory that high trading

volume can partially be explained by investor overconfidence. They show that current trading activity in the stock market is

positively correlated with past stock market returns for several months. Puetz and Ruenzi (2011) find that equity mutual fund

managers trade more after good past performance, which is consistent with the theory of overconfidence. While these studies

support the argument of overconfidence in the stock market, they do not address the issue of overconfidence in the options

market.

Options were deemed as “redundant” assets according to Black and Scholes (1973) and Cox, Ross, and Rubinstein (1979),

as they are replicable in a complete market by a simple synthetic strategy involving the asset underlying the option and a risk-

free bond. However, the existence of transaction costs and short- sell constraints may prevent the market from being complete,

and therefore, induce trading in the options market. In addition, Black (1975) argues that options have a leverage advantage

over stocks, which provides an additional incentive for investors to exploit their private information in the options market.

Consequently, if investors are overconfident about their trading skills or private information, they may also be motivated to

Received: 19 June 2018

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Accepted: 19 August 2018

DOI: 10.1002/rfe.1048

SPECIAL ISSUE ARTICLE

Overconfidence among option traders

Han-Sheng Chen1

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Sanjiv Sabherwal2

1Department of Accounting and

Finance,Southeastern Oklahoma State

University, Durant, Oklahoma

2Department of Finance and Real

Estate,University of Texas at Arlington,

Arlington, Texas

Correspondence

Sanjiv Sabherwal, Department of Finance

and Real Estate, University of Texas at

Arlington, Arlington, TX.

Email: sabherwal@uta.edu

Abstract

The investor overconfidence theory predicts a direct relationship between market-

wide turnover and lagged market return. However, previous research has examined

this prediction in the equity market, we focus on trading in the options market.

Controlling for stock market cross- sectional volatility, stock idiosyncratic risk, and

option market volatility, we find that option trading turnover is positively related to

past stock market return. In addition, call option turnover and call to put ratio are also

positively associated with the past stock market return. These findings are consistent

with the overconfidence theory. We also find that overconfident investors trade more

in the options market than in the equity market. We rule out explanations other than

investor overconfidence, such as momentum trading and varying risk preferences,

for our findings.

JEL CLASSIFICATION

G02, G10

KEYWORDS

behavioral finance, options market, overconfidence, trading volume

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CHEN aNd SaBHERWaL

trade actively in the options market. Furthermore, Hirshleifer and Luo (2001) predict that higher volatility in the underlying

security payoff would lead to a higher proportion of overconfident traders. Their prediction, in turn, also makes one wonder

whether overconfident traders may also influence the options market.

In view of the above arguments, we expect to find similar, if not stronger, evidence in support of the overconfidence theory

in the options market. However, t he overconf idence theory has not been tested in the options market. Our main objective in t his

study is to empirically examine whether investor overconfidence is associated with high trading activity in the options market.

Our results provide evidence in support of the overconfidence theory in the options market. We use various measures of

trading activities in the options market and show that past stock market return is positively related to option trading activities.

We find that options trading, especially in call options, increases with past market returns. Shefrin and Statman (2000) propose

that investors consider call options, and not put options, as a way to hit the jackpot. In contrast, put options are considered as

insurance against downside risk. Investors are more likely to buy call options than short put options if they expect an upward

movement in stock price. Accordingly, we also examine the relationship between call to put ratio and past market return, and

find a positive relationship.

In addition, we investigate whether overconf ident investors are motivated to trade more in the options market than in the

equity market. We analyze the O/S measure introduced by Roll, Schwartz, and Subrahmanyam (2010), which captures trading

activity in options relative to the trading activity in underlying stocks. We f ind a positive relationship between O/S and past

market return, which suggests that overconfident investors are more active in the options market than in the equity market.

We further explore whether firm characteristics affect the relationship between investor overconfidence and option trading

volume. Specifically, we examine the effects of firm size, book- to- market equity (BE/ME) ratio, and coverage by financial

analysts. We find that the greater use of call options relative to put options after good market performance is more prevalent for

larger firms and firms with a low BE/ME ratio or glamor firms. We also find evidence consistent with the argument that low

information efficiency leads to more overconfidence, as the relationship between past market return and option trading volume

is stronger in firms with no financial analyst coverage.

We examine whether there could be explanations other than investor overconfidence for our findings. In particular, we

examine whether momentum strategies and varying risk preferences can explain our results. We find t hat neither of the above

explanations can account for the positive relationship between past market return and option trading activities.

The remainder of this paper is structured as follows: in Section 2, we provide a detailed literature review regarding investor

overconfidence and options trading. Section 3 descr ibes our hypotheses. In Section 4, we discuss the methodology used to

test our hypotheses and the definitions of our variables. Section 5 describes the data and provides some summary statistics.

Section 6 presents the results of empirical analysis for the full sample using the main and alternative dependent variables and

subsamples based on firm characteristics. It also examines potential explanations other than overconfidence for our findings.

Section 7 summarizes the findings and provides potential extensions of this study for future research.

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LITERATURE REVIEW

Investor overconfidence is well documented in the equity market. Daniel et al. (1998) develop a theoretical framework that ex-

plains under- and over- reactions in the equity market, based on the well- known psychological biases of investor overconfidence

and biased self- attribution. Odean (1998) and Gervais and Odean (2001) develop a model in which noise traders2 self- attribute

the high returns experienced to their trading skills, even though the overall market also enjoys similar results. Thus, aggregate

overconfidence is higher after market gains. With the model showing that greater overconfidence leads to greater trading vol-

ume, trading volume is likely to be greater after market gains. Statman et al. (2006) use a comprehensive dataset from the U.S.

exchanges to empirically test the above prediction and confirm that market turnover is positively correlated with past market

returns. They interpret this finding as evidence of investor overconfidence. Kim and Nofsinger (2007) present evidence that

investor overconfidence exists not only in the U.S. equity market, but also in the Japanese market. Griffin, Nardari, and Stulz

(2007) extend the discussion to 46 countries and find that many of them exhibit a positive relationship between stock turnover

and past stock market return. Glaser and Weber (2009) suggest that both past market returns and returns of portfolios held by

individual investors affect the trading activities of those investors.

The above stream of literature focuses exclusively on the equity market. Participants in the equity market are also likely

to participate in the options market for speculating or hedging purposes. Though financial options were deemed as redun-

dant securities in Black and Scholes (1973) and Cox et al. (1979), the options market has drawn significant attention. Ross

(1976) and Arditti and John (1980), for example, present theoretical work to address the ability of options to “complete” the

market. Figlewski and Webb (1993) follow prior work and argue that the options market contributes to both transactional and