[JOB MARKET PAPER] Does the Tail Wag the Dog? How Options Affect Stock Price Dynamics

Abstract:

We demonstrate empirically that the existence and trading of options affects the autocorrelation of stock returns. Dynamic hedging by option writers creates an upward sloping demand curve: when the stock price rises, option writers must buy more stock to remain hedged. Because option writers do not adjust their hedges instantaneously, their hedging increases the autocorrelation of stock returns. We study how the hedging of options on individual stocks affects stock return autocorrelations in the cross section. We develop a measure of “hedging demand” that quantifies the sensitivity of the option writers' hedge to changes in the underlying price. As we move from the lowest to highest quintile of hedging demand, the daily return autocorrelation increases from -5.0% to -1.6%. In a portfolio sorting strategy, the high-minus-low-quintile return spread has an alpha of 0.33% weekly (18% annualized). To address potential confounds, we use an instrumental variable for hedging demand, the absolute difference between the underlying stock price and the nearest round number. This instrument uses the institutional idiosyncrasy that exchange-traded options have round number strike prices.