The Effects of Investor Sentiment on Speculative Trading and Prices of Stock and Index Options

Abstract

We find that the demand for stock option positions that increase exposure to the underlying is positively related to measures of investor sentiment and past market returns, while the demand for index options is invariant to these factors. These differences in trading patterns are reflected in differences in the composition of traders in the different types of options -- Options on stocks are actively traded by individual investors, while trades in index options are more often motivated by hedging demands of sophisticated investors. Consistent with a demand based view of option pricing, we find that sentiment is related to time-series variation in the slope of the implied volatility smile of stock options, but has little impact on the prices of index options. The pricing impact is more pronounced in options with a higher concentration of unsophisticated investors and in options with higher hedging costs. Our results provide new evidence factors not related to fundamentals affect price of securities actively traded by noise traders.