On the Causal Effect of Option Trading on Underlying Stock Pricing

Abstract

This paper shows that option trading does not reduce overpricing in the underlying stock market. A popular view in the literature is that options lower short selling cost, therefore, they allow stock prices to better incorporate negative information and opinions. Testing such a hypothesis is challenging because certain variables can drive both option trading and stock pricing, and failure to control for these variables gives rise to endogeneity issues. We develop an instrumental variable for option trading volume and use it to show that exogenous increase in option trading leads to more severe overpricing, which contradicts the existing view. Specifically, the instrumental variable is the distance between two adjacent option strike prices measured as a percentage of the underlying stock price.