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Overcoming Arbitrage Limits: Option Trading and Momentum Returns

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Overcoming Arbitrage Limits: Option Trading and Momentum Returns” by Abhay Abhyankar, Ilias Filippou, and Pedro Angel Garcia-Ares examines the role of option trading in influencing the decline of momentum profitability.

The study highlights how momentum profits mainly stem from the short leg, which, in turn, depends on barriers to short selling. The authors present strong evidence that the availability of stock options results in alternative avenues for short selling and enhances the stock lending market, thereby contributing to improved pricing efficiency.

However, when options trading becomes costly, the short position yields lower returns. Notably, the study shows that its findings hold true even when analyzing stocks with and without options, based on eligibility criteria for optionability, indicating that firm-level characteristics cannot account for the significant differences in the profit generated from the two strategies.

Abstract Of Paper

We find that the decline in momentum profitability is partly driven by option trading. Momentum profits arise from the short leg and therefore on barriers to short selling. We find strong evidence that the presence of stock options creates alternate avenues for short selling, augmenting the stock lending market, thus contributing to improved pricing efficiency. However, when options trading becomes expensive, the short position offers lower returns. We find that our results remain unchanged when we match the universe of stocks with and without options based on variables that determine the eligibility of a stock to be optionable, indicating that firm-level characteristics cannot account for the significant differences in the profitability of the two strategies.

Original paper – Download PDF

Here you can download the PDF and original paper of Overcoming Arbitrage Limits: Option Trading and Momentum Returns.

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Author

Abhay Abhyankar
MOVE,Departament d’Economia i d’Història Econòmica, Universitat Autònoma de Barcelona

Ilias Filippou
Washington University in St. Louis – John M. Olin Business School

Pedro Angel Garcia-Ares
Instituto Tecnológico Autónomo de México (ITAM)

Conclusion

In conclusion, the research paper “Overcoming Arbitrage Limits: Option Trading and Momentum Returns” by Abhay Abhyankar, Ilias Filippou, and Pedro Angel Garcia-Ares establishes a link between the decline in momentum profitability and the role of option trading.

The study uncovers compelling evidence that stock options availability creates alternative avenues for short selling, enhancing the stock lending market and promoting pricing efficiency. However, the downside is that expensive options trading results in lower returns on short positions.

Importantly, the authors show that their findings persist even after considering stocks with and without options, based on optionability criteria, suggesting that firm-level characteristics do not explain the profitability variations between the two strategies.

This research contributes valuable knowledge to the domain of momentum returns and the impact of option trading, providing investors with a more comprehensive understanding of the dynamics influencing profitability.

Related Reading:

Mandelbrot Market-Model and Momentum

Over or Under? Momentum, Idiosyncratic Volatility and Overreaction

FAQ

Q1: What is the main focus of the research paper by Abhay Abhyankar, Ilias Filippou, and Pedro Angel Garcia-Ares?

The research paper investigates the role of option trading in influencing the decline of momentum profitability. It explores how momentum profits, particularly from the short leg, are impacted by the presence of stock options and the barriers to short selling.

Q2: What evidence does the study provide regarding the impact of stock options on momentum profits?

The study presents strong evidence that the availability of stock options creates alternative avenues for short selling, contributing to an improvement in pricing efficiency and influencing momentum profits. However, the research notes that when options trading becomes expensive, the short position offers lower returns.

Q3: How does the research consider the differences in profitability between stocks with and without options?

The authors match the universe of stocks with and without options based on variables determining the eligibility of a stock to be optionable. The findings indicate that firm-level characteristics cannot account for the significant differences in the profitability of the two strategies, emphasizing the role of option trading in influencing momentum returns.

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