The Price Impacts of Index Option Hedging and the Anomalous Weekly Reversals

Abstract

This paper shows that hedging by index option writers generates significant price pressure on the market as a whole, resulting in market return reversals. Furthermore, this aggregate hedging pressure affects some stocks more than others, causing cross-sectional dispersion of pricing errors and cross-sectional return reversals. Specifically, we find that market returns following monthly index option settlements are negatively correlated with signed delta hedging volume preceding settlements. In addition, the cross-sectional weekly reversal anomaly in recent years concentrates around option expiration and a significant portion of it can be explained by index option hedging pressure. Based on the theoretical argument that option hedging trades are more likely to generate pricing errors approaching option expiration and the exogeneity of the option expiration calendar, the above patterns can be attributed to option hedging effects. Evidence also suggests that option hedging can impact seemingly liquid underlying markets by amplifying existing order imbalances. In terms of implications for option pricing, we find that index option prices tend to be high before option expiration, suggesting that option hedgers are attempting to control their inventories of written options that might be difficult to hedge due to the price impact. Collectively, our evidence brings new insights to the literature on the interaction between primary markets and derivative markets and the broad topic of market efficiency.