Sunday, January 18, 2015

How does stock option impact stock prices?

How does stock option trading impact the stock prices? This is an interesting topic that many professional researchers trying to figure out. I had always thought options had minimal effects on the prices of the underlying other than the pinning to heavily traded option strikes at the expiration (pin risk) dates. This was in-line with the posted view expressed by Thomsett, the author of an option book:

However, after a recent study of a couple of academic papers and an investment company report, I found there are some evidences of the option trading that impacts the stock prices. The academic papers also provide theoretical models along with the empirical data (which I don't fully understand).

N. Pearson, et. al. of University of Illinois at Urbana-Champaign published a paper titled "Does Option Trading Have a Pervasive Impact on Underlying Stock Prices?" on Feb. 23, 2007. The paper introduces the following areas of research on how options impact underlying stock prices and mentioned that there were no conclusions before their publishing date except for the pinning:

  • Whether option generation has a one-time price impact
  • Whether option activities cause systematic price change at expiration dates (pinning)
  • whether options produce pervasive changes in stock prices

They reported that there are about 12% of optioned stock daily absolute return that can be accounted for by option trader's hedging of their option positions. This constituted the first evidence that the option markets have a pervasive influence on underlying stock prices.

More recently, D. Yang, et. al. of Harvard published another paper titled "Does the Tail Wag the Dog? How Options Affect Stock Price Dynamics" on Dec. 13, 2014.  They demonstrated that institution call option sellers would buy stocks to hedge their short calls. It would create an upward trend. If the dynamic hedging is larger, the upward trend curve increases the auto-correlation of stock return in a higher degree. The opposite is true for institutional put selling.

Finally, a recent report from a Shanghai investment company studied the underlying stock price rising magnitude as a result of the very first introduction of options for the stock in a large number of countries. It claims that it's a worldwide phenomena that underlying stock prices would increase in the first month of the initial option introduction for the stock. The report thus asserts that Chinese stock market will rise this month since stock options are introduced for the first time in Chinese stock market.

The US stock market is included in this study. It finds that US stock prices increased, on average, an annualized rate of 50.4% in the very first month of option introduction. Comparing to S&P 500, the initially-optioned stock prices outperformed S&P500 by 45% in that month. The report states it would be a high probability event for the fundamentally sound stocks to rise during their 1st month of option introduction. Since there is no detailed information about the number of stocks used in the study and the years of the stock trades used in the study, I was not very sure about this result.

Therefore, I spent some time to verify this study a little bit. I reviewed the stock and option trading history for two of my positions on China: HAO & FXI. To my surprise, the first month price rise were 5.4% for them during the 1st month of option introduction. This is close to the average annualized rate provided by the report. Accidental or not, it gives me a little bit feeling of credibility of this report.
FXI StockAvail 10/12/2004
OptionAval 10/15/2004
StockPrice 17.21
1CycleLater 18.14
Percentange 5.40%
ATMExpireOI 904
HAO StockAvail 1/30/2008
OptionAval 5/27/2009
StockPrice 20.25
1CycleLater 21.34
Percentange 5.38%
ATMExpireOI 11


  1. The first month rise is not a surprise. Option Market Makers need to acquire the underlying to do what they do.

    1. Thank you so much for the comment. It totally makes sense for me now.