Abstract
AbstractIf the trading of noise traders is highly correlated and arbitrage risk exists, stock prices can deviate from their fundamental value. In particular, due to the short‐selling impediments, stock prices tend to be overpriced. We hypothesize that the idiosyncratic volatility (IVOL) puzzle is due to this overpricing caused by noise traders that can be proxied by retail traders, and provide evidence supporting it. Our empirical findings are as follows. First, the IVOL puzzle is more prominent among stocks with a high retail trading proportion (RTP). Second, the negative relation between IVOL and stock returns is stronger following high retail sentiment. Finally, return reversals for stocks with high RTP and high IVOL are observed.
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