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

Abstract

We find that speculative demand for equity options is positively related to investor sentiment, while hedging demand is invariant to sentiment. 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 higher concentration of speculative trading, higher transactions costs, higher stock return volatility, and smaller stock size. Our results suggest that the correlated biases of noise traders affect the trading and prices of securities that are subject to speculation, but do not affect prices of securities in which demand is driven by hedging motives unrelated to sentiment. JEL Classification Code: G1