Trading, Ambiguity and Information in the Options Market

We study how firm ambiguity—Knightian uncertainty—affects investor trading behavior using the options market as a laboratory. Greater ambiguity in the underlying asset negatively relates to both options open interest and options trading volume. The reduction in options trading activity is stronger for options with shorter maturities and out-of-the-money options that are hard-to-value. Greater ambiguity is also associated with a reduction in the informativeness of options trading for future stock prices, and it is associated with lower delta-hedged options returns for both puts and calls. The effect of ambiguity is distinct from and contrasts with the well-documented effect of risk, and it shares a similar economic significance. These findings illustrate that even sophisticated market participants, like options traders, are influenced by ambiguity to limit their market participation and trade less.