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Is investor misreaction economically significant? Evidence from short‐ and long‐term S&P 500 index options

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  • Charles Cao
  • Haitao Li
  • Fan Yu

Abstract

Several recent studies present evidence of investor misreaction in the options market. Although the interpretation of their results is still controversial, the important question of economic significance has not been fully addressed. Here this gap is addressed by formulating regression‐based tests to identify misreaction and its duration and constructing trading strategies to exploit the empirical patterns of misreaction. Regular S&P 500 index options and long‐dated S&P 500 LEAPS are used to find an underreaction that on average dissipates over the course of 3 trading days and an increasing misreaction that peaks after four consecutive daily variance shocks of the same sign. Option trading strategies based on these findings produce economically significant abnormal returns in the range of 1–3% per day. However, they are not profitable in the presence of transaction costs. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:717–752, 2005

Suggested Citation

  • Charles Cao & Haitao Li & Fan Yu, 2005. "Is investor misreaction economically significant? Evidence from short‐ and long‐term S&P 500 index options," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 25(8), pages 717-752, August.
    • Handle: RePEc:wly:jfutmk:v:25:y:2005:i:8:p:717-752
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    Cited by:

    1. Choy, Siu-Kai, 2015. "Retail clientele and option returns," Journal of Banking & Finance, Elsevier, vol. 51(C), pages 26-42.
    2. Seo, Sung Won & Kim, Jun Sik, 2015. "The information content of option-implied information for volatility forecasting with investor sentiment," Journal of Banking & Finance, Elsevier, vol. 50(C), pages 106-120.
    3. Chin‐Ho Chen, 2021. "Investor sentiment, misreaction, and the skewness‐return relationship," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(9), pages 1427-1455, September.
    4. Yen-Sheng Lee, 2022. "Representative Bias and Pairs Trade: Evidence From S&P 500 and Russell 2000 Indexes," SAGE Open, , vol. 12(3), pages 21582440221, August.

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