The Effects of I nvestor Sentiment on Speculative Trading and Prices of Stock

and I ndex Options

Michael Lemmon

Sophie Xiaoyan Ni
*

August 2011





JEL Classification Code: G1
Key Words: Options, Volatility Smile, Sentiment, Speculation, Hedging

Lemmon is at the University of Utah and the Hong Kong University of Science and Technology, email:
michael.lemmon@business.utah.edu. Ni is at the Hong Kong University of Science and Technology, email:
sophieni@ust.hk. We benefited from the comments and support of Mark Grinblatt, John Griffin, Ohad Kadan (IDC
Caesarea discussant), Neil Pearson, Allen Poteshman, Maik Schmeling (EFA discussant), Mark Seasholes, J ason
Wei, Ning Zhu and seminar and symposium participants at the Hong Kong University of Science and Technology.
We bear full responsibility for any errors. The financial support from a Hong Kong RGC Research Grant (Project #
642908) is gratefully acknowledged.










ABSTRACT
We find that the demand for stock option positions that increase exposure to the underlying is
positively related to measures of investor sentiment and past market returns, while the demand
for index options is invariant to these factors. These differences in trading patterns are reflected
in differences in the composition of traders in the different types of options---Options on stocks
are actively traded by individual investors, while trades in index options are more often
motivated by hedging demands of sophisticated investors. Consistent with a demand based view
of option pricing, we find that sentiment is related to time-series variation in the slope of the
implied volatility smile of stock options, but has little impact on the prices of index options. The
pricing impact is more pronounced in options with a higher concentration of unsophisticated
investors and in options with higher hedging costs. Our results provide new evidence factors not
related to fundamentals affect price of securities actively traded by noise traders.





1








The traditional view on asset pricing posits that the price of a security closely reflects the
present value of its future cash flows. According to this efficient market hypothesis (EMH), price
movements are driven by changes in the asset fundamental values, with irrational sentiment
playing no role because the actions of arbitrageurs readily offset such shocks. An alternative
theory argues that the dynamic interplay between sentimental noise traders and rational
arbitrageurs establishes prices (Delong, Shleifer, Summers, and Waldman(1990) ). According to
this behavioral hypothesis (BH), in addition to innovations in fundamentals, factors such as
systematic sentiment of noise traders also induce movement of asset prices if assets are held
predominantly by noise trader, and arbitrage forces will not fully correct the prices.
A perfect setting to test the two alternative theories would be the existence of two
identical securities in a market with friction, of which the only difference is that one security is
traded by rational investors, and the other is held by noise traders. EMH would predict that the
two securities will have same price movements. While the behavioral view would foretell that
the prices of two assets will behave differently; the correlated sentiments of noise traders will
affect the security held predominantly by noise traders, but not the security traded mainly by
rational investors. Its difficult, however, to find this ideal setting in the stock market except for
the close end fund; the securities that traded mainly by noise traders are usually different from
securities that traded by rational investors. Because of the joint hypothesis problem (Fama
(1970)), any return disparity between these two types of securities can be attributed to the
fundamental differences of the securities rather than the type of investors who are trading them.
2








Our main purpose is to test the two alternative views on asset pricing using stock and
index options as experimental objects. Stock options in aggregate and index options are close to
identical in the sense that their underlying securities are driven by the same fundamentals, and
that their prices are affected by jump and volatility risks in similar ways. If we assume individual
investors are noise traders, then individual investors trading stock options much more actively
than index options gives us an ideal setting to test the two alternative asset pricing theories. In
addition, high transaction costs, margin requirements, and difficulties in short selling are more
likely to impede arbitrage activities in option markets (Figlewski (1989), Pontiff (1996)).
In testing the two alternative asset pricing theories, we focus on whether stock and index
options respond to sentiment and past market return differently. In addition to barometers of
behavioral biases, sentiment and past return can also be interpreted as signals of shifts in risk
preference or changes of fundamentals (Lemmon and Portniaguina (2006)). Unlike other studies
drawing conclusion based on a definite interpretation of sentiment, our tests on the simultaneous
responses of stock and index options to the sentiment do not require any assumption about
economic meaning of sentiment. EMH predicts that stock options in aggregate and index options
will respond to the sentiment in a similar way regardless what sentiment stands for. While BH
predicts if the sentiment is associated with correlated noise trader biases, we will observe
different reactions from stock and index options, for stock options are traded actively by
individual investors while index options are held dominantly by rational investors for hedging
purposes (Bollen and Whaley (2004)). In other words, different responses of stock and index
options to sentiment or lagged return in certain directions imply that the BH is valid and
3

sentiment is an indicator of behavioral biases. On the other hand, no valid conclusion can be
drawn if same responses (including no response) of stock and index options to sentiments are
detected.
We begin our study by showing that prices of stock and index options are driven by same
risk factors. Adopting a model with stochastic volatility with return jumps, we simulate that the
implied volatility functions (IVFs) of stock and index options respond in similar ways to the
variations in jump and volatility risks.
We then pursue two strands of empirical investigation to examine the link between
sentiment, past market return and option market. In order for behavioral bias to impact asset
prices, it must be associated with the trading of that asset. Our first empirical investigation
examines how trading activities of stock and index options are influenced by sentiment and
previous month market returns. Our measure of sentiment is the index of consumer sentiment
(CS) from University of Michigan adjusted for macroeconomic factors and used in Lemmon and
Portnaiguina (2006)
1
. We believe consumer sentiment is likely to be a proxy for behavioral bias
of noise traders because it is based on a survey on individual households. Our use of stock return
is motivated by the fact that changes in stock valuations are also likely to be associated with the
potential for overreaction by unsophisticated traders.
In our data, trading by unsophisticated investors (defined as discount brokerage
customers or small trades) accounts for at least 14% or 32% of total non-market maker volume
for stock options, but only 3% of index option volume. To measure investor demand for different

1
DeLong, Shleifer, Summers and Waldman (1990)) interpret sentiment as capturing the correlated beliefs of
investors that are unrelated to fundamentals.
4








types of options we construct a measure we call the positive-exposure demand for individual
stock options (PDS), and positive-exposure demand for SP500 index options (PDI). The
variables PDS and PDI measure the monthly non-market maker net option demands with
positive exposure to the underlying stock and the index, respectively. We focus on PD rather
than net option demand because sentiment is more likely to drive investors to speculate on the
direction of underlying stock price movements. To the extent that stock option trading is related
to aggregate changes in investor sentiment we expect that PDS will be positively related to
consumer sentiment and past stock returns, while PDI, which is primarily dominated by rational
trades, will be unrelated to sentiment or past stock returns. The evidence is consistent with these
predictions. Over the period from 1990 through 2008, time-series variation in PDS is increasing
in consumer sentiment and lagged market return, while PDI is unrelated to the sentiment or
market return. We also find that changes in PDS are most strongly related to changes in
sentiment and lagged returns for trades initiated by customers of discount brokers and in small
option trades.
Our second empirical investigation examines the pricing impact of sentiment and lagged
market return on stock and index options. The dependent variable is the slope of the IVF
computed as the difference in implied volatility between OTM calls and OTM puts. If consumer
sentiment and past returns are proxies for changes in fundamentals, the slopes of IVF of stock
and index options will respond to sentiment and lagged market return in similar ways. On the
other hand, if consumer sentiment and lagged market return are proxies for behavioral biases, we
expect the prices of stock options to respond more strongly to sentiment and lagged market
5








return than prices of index options. In multivariate regressions that control for the lagged
dependent variable, contemporaneous market returns, volatility, and a measure of institutional
investor sentiment, we find that both the consumer sentiment and lagged market return are
positively related to the slope of the implied volatility function for options on individual stocks.
In contrast, we find no evidence that past market return or consumer sentiment is related to the
slope of the implied volatility function for S&P500 index options. Similar to Han (2008), we do
find that the slope of the IVF for index options is related to a measure of institutional investor
sentiment, but that institutional investor sentiment is not significantly related to slope of
volatility smile for options on individual stocks.
Also consistent with the view that sentiment significantly affects option prices we find
evidence of positive abnormal returns from contrarian trading strategies that trade calls and puts
on individual stocks following large changes in sentiment and market returns. In some cases
these abnormal returns exceed option transactions costs.
Finally, we examine whether the effects of sentiment on stock option trading and prices
vary cross-sectionally. As predicted by models of limited arbitrage, we find that options with a
higher proportion of trading from less sophisticated investors, and those with higher underlying
volatility and volatility of volatility exhibit trading and prices that are more sensitive to
sentiment.
Our study provides new evidence on how factors not related to fundamentals affect
security prices in a unique angle. Our conclusion relies on that prices of stock and S&P500
index options are driven by same fundamentals in a rational setting. Its possible that therere
6








systematic factors other than BH influence stock and index option prices differently, for
example, stock options are less liquid than index options. However, for our findings to be driven
by liquidity, it would need to be the case that liquidity is associated with trading and price of
stock options only. It is not easy to see why aggregate liquidity does not impact index options,
given Cherks, Sagi and Stanton (2009) and Bao, Pan and Wang(2010) documenting that liquidity
commoving more closely with VIX index than consumer sentiment. Indeed, we find that
liquidity is not an alternative explanation for the role of consumer sentiment.
Our paper is related to the literature examining the relation between investor sentiment
and security prices in the stock market. For example, Lee, Shleifer and Thaler (1991) and Pontiff
(1996) propose that fluctuations in the discounts of closed-end fund (CEF) are driven by changes
in individual investor sentiment, while Cherkes, Sagi and Stanton (2009) show that the CEF
discounts emerge from the tradeoff between the funds liquidity benefits and management fees.
Baker and Wurgler (2006) and Stambaugh, Yu and Yuan (2011) present evidence that investor
sentiment has significant effects on the cross-section of stock prices. Lemmon and
Portniaguina(2006) show that consumer confidence predicts returns of small stocks. Kumar and
Lee (2006) document that individual investor trades are systematically correlated and can explain
the return co-movements for stocks with high retail investor concentration. In more recent study,
Kaplanski and Levy (2010) show that bad mood arising from aviation disaster is associated with
stock market declining.
7








Our paper is also related to studies examining trading and pricing of equity options.
Bollen and Whaley (2004) document that the excess implied volatility of S&P500 index options
is much higher than that of stock options. They attribute this fact to the hedging demand for
index put options as portfolio insurance against market decline. Grleanu, Pedersen, and
Poteshman (2009) confirm their finding and model that demand imbalances generated by the
trades of end users can affect option prices. Bates (1991, 2000), Heston (1993) J ackwerth and
Rubinstain (1996), Pan (2002), and among others show IVF is driven by stochastic volatility and
jump risks. Amin, Coval and Seyhun (2004) document that SP100 index call (put) prices are
overvalued following large upside (downside) market movements. Bakashi, Kapadia and Madan
(2003) document that the risk neutral skewness in stock option prices is less negative than that
index option prices because of idiosyncratic component in stock returns.
Our paper is also related to the study examining differences in cross sectional trading and
pricing of options on individual stocks. Lakonishok, Lee, Pearson and Poteshman (2007) find
that stocks with high past returns have high option volumes of both purchased call and put, and
during the bubble of the late 1990s, the least sophisticated investors increased their purchase of
calls on growth stocks. However they do not systematic examine how sentiment and lagged
return relate to the aggregate trading and price of stock options, nor do they compare differences
in stock and index option. Poteshman (2006), Yan (2010), and Zhang, Zhao and Xing (2010)
document that stock option purchased put-call ratios and implied volatility slope contain
information about future stock returns. Duan and Wei (2009) find systematic risk also impact
IVF of 30 largest stocks. The above studies focus on cross sectional differences in stock options,
8








while our study is based on time series variations in aggregate trading and pricing of all stock
options. Roll, Schwartz and Subrahmanyam (2009) investigate the relative volume in options and
stock markets, and argue that the determinants of option volume are not well understood. Our
study partially answers this question.
Finally, our findings are related to studies that document behavioral biases in options
markets. Stein (1989) documents that longer term implied volatilities of S&P 100 index options
overreact to changes in short-term volatility. Poteshman and Serbin (2003) document option
investors early exercise American options irrationally. Constantinides, J ackwerth and Perrakis
(2009) find no evidence that prices in the S&P500 index options have become more rational over
time. Han (2008) documents a positive relationship between the risk-neutral skewness in
S&P500 index option prices and measures of institutional investor sentiment.
The remainder of the paper is structured as follows. Section 1 shows that risks affect
prices of stock and index option in similar ways. Section 2 presents data and variable
construction. Section 3 presents summary statistics and trading activity of different investors on
stock and index options. Section 4 shows the results and Section 5 concludes.

1. I ndex and Stock Option Prices
In this section, we show that risks affecting IVF of index option have same impact on
IVF of stock option. Adopting a model with stochastic volatility and return jumps, we assume
the following data-generating process for index price I under physical probability measure (to
simplify exposition, we assume zero dividend and constant risk free rate):
9









JI
t
= |r +p
s
I
t+
zp
t
]
]I
t
Jt +I
t
I
t
Jw
t
1
+I
t
JZ
t
-zpI
t
Jt, (1)
JI
t
= (: -I
t
)Jt +o

I
t
_p
12
Jw
t
1
+_1 - p
12
2
Jw
t
2
_, (2)
where r is interest rate, w = |w
1
, w
2
] is a standard Brownian motion in R
2
, Z is index price
jump process with jump probability z , jump volatility o
]
and average relative jump size p
conditional on jump occurs, p
s
is the premium for conventional return risks, and zp
t
]
is the jump
risk premium. In this model, we set jump size premia p
t
]
time varying to reflect the time series
variation in jump risk. Eq.(2) models stochastic volatility with constant long-run mean : , mean-
reversion rate , instantaneous variance I
t
, volatility coefficient o

, and correlation coefficient of

the return and the volatility p
12
.
Suppose an individual stock has beta one on index excess returns. Its price S has the
following data generating e proc ssunder physical probability measure P:
JS
t
= |r +p
s
I
t
+zp
t
]
]S
t
Jt +I
t
S
S
t
[p
13
Jw
t
1
+1 -p
13
2
Jw
t
3
+S
t
JZ
t
-zpS
t
Jt +
S
t
JZ
t
S
, (3)
JI
t
S
= JI +JI

, (4)
t t
JI
t

(:

-I
t

)Jt +o

_I

[p
34
Jw
t
3
+1 -p
34
2
Jw
t
4
, (5)
t
10

where I
t
S
is stock variance, w

= |w
3
, w
4
] is a standard Brownian motion in R
2
and
uncorrelated with |w
1
, w
2
] , p
13
is the correlation coefficient between index the stock returns,
and Z
S
, uncorrelated with index jump Z, is the stock idiosyncratic jump with jump probability





11



z
S
, average relative jump size 0 and jump size volatility o
S,]
. We assume when index jump
occurs, the stock price S appreciates or depreciates by same return as the index price I does.
As |w
1
, w
2
] and |w
3
, w
4
] are uncorrelated and stock market beta is one, Eq.(4)
shows the change of stock variance is the sum of changes in index variance (I
t
) and stock
idiosyncratic variance (I
t

). Eq. (5) shows the stock idiosyncratic variance also follows a mean
reversion stochastic process.
Based on the above setting, the corresponding dynamic of index price I under risk neutral
probability measu l re Q is as folows:
JI
t
() = rI
t
Jt +I
t
I
t
Jw
t
1
+I
t
JZ
t

-z(p -p
t
]
)I
t
Jt, (6)
JI
t
() = |(: -I
t
)Jt +p
t

I
t
]Jt +o

I
t
jp
12
Jw
t
1
+1 -p
12
2
Jw
t
2
[, (7)

where w() = |w
1
, w
2
] is a Brownian motion under Q, and p
t

is the time varying volatility

premium. The jump process Z

has a distribution under Q that is identical to the distribution of Z

under P, except that under Q, the average jump size is p -p
t
]
.
The corresponding dynamic of stock price S under risk neutral probability measure is as
follows:
JS
t
() = rS
t
Jt +I
t
S
S
t
[p
13
Jw
t
1
+1 -p
13
2
Jw
t
3
+S
t
JZ
t

-z(p -p
t
]
)S
t
+
S
t
JZ
t
S
(8)
JI
t
S
() = JI
t
() +JI
t

, (9)
where I
t
() is the variance of index under Q, and I
t

is the idiosyncratic variance under Q.

Idiosyncratic variance earns zero risk premium, its dynamic under Q is same as that under P.

We assume systematic risk influences option prices through time varying jump size
premium (p
t
]
) or variance premium (p
t

), and use simulation to investigate their impacts on

option implied volatility function (IVF).
2
We omit the pricing impacts from changes in physical
jump size, jump probability or physical volatility because these changes have same effects as the
variations in jump size premium or variance premium.
We show in Figure 1 that the jump and volatility risks have same impacts on IVF of
index and stock options. When jump size premium increases,
3
the slopes and the levels of IVF
become more negative for both index and stock options. Similarly, when the variance premium
increases,
4
the levels of IV increase for both options. These patterns suggest that if a systematic
risk influences option prices, it must affect IVF of stock and index options in similar ways.
Figure 1 also shows that the slope of stock options IVF is flatter and more volatile than
that of index options. This result is consistent with that documented in Bakshi, Kapadia and
Madan (2003), who show idiosyncratic components in stock returns drive risk neutral skewness
of stocks to be less negative and more volatile than that of index.

2. Data and Variables
In this section we describe the option and sentiment data and provide summary statistics
for the main variables used in our analyses.
2.1. Option trading and price data

2
We use following parameter values in simulation: r = u.u2, z = z
S
= u.19, p = -u.u2, =
i
= 6.4, : = u.u16,
o

= u.uS, o
]
= u.uS9, p
12
-u.SS, p
13
= u.2S, o
S]
= u.uS9, :
i

= u.16, o

i
= u.S, p
34
= -u.2S. The
parameters associated with in option is similar to those in Pan (2002), and the option maturity is 30 trading days.
12

=
d
3
The variance risk premium, b is fixed at 3.1.
ex

,
4
The jump size risk premium, b
]
, is fixed at 0.17.

The data used to compute option trading activity is obtained from the CBOE. The data
set contains daily non-market maker volume for all CBOE-listed options from J anuary 1990
through September 2008. The number of stocks having CBOE traded options in each month
increases from 239 in J anuary 1990 to 2,449 in December 2008, reflecting the dramatic growth
in the option market during the sample period.
For each option, the daily trading volume is divided into four types of trades: open-buy,
in which non-market markers buy options to open new long positions, close-buy, in which non-
market makers buy options to close out existing written option positions, open-sell, in which
non-market makers sell options to open new short positions, and close-sell, in which non-market
makers sell options to close out existing long options positions.
The data on option prices are compiled from the Berkeley Option Database and Ivy
OptionMetrics. The time period covered in this study is also from J anuary 1990 to September
2008. We obtain option price data from the Berkeley Option Database for the period from 1990
to 1995. The option price data from 1996 to 2008 are obtained from OptionMetrics. For the first
part of the data period, we follow Bollen and Whaley (2004) and compute daily option implied
volatilities from the midpoint of the last bid-ask price quote before 3:00 PM Central Standard
Time.
5
Starting in J anuary 1996 we use the implied volatilities supplied by OptionMetrics.
We use the implied volatility on the last trading day of the month for options that meet
the following four conditions: (1) the option has above zero trading volume on that day, (2) the

5
For American-style stock options we use the dividend-adjusted binomial method with the actual dividends paid
over the life of an option as a proxy for the expected dividends. For SPX index options, which are European, we
compute implied volatilities by inverting the Black-Scholes (1973) formula. Linearly interpolated LIBOR is used as
the risk free rate.
13

option bid price is larger than zero and within standard no-arbitrage bounds
6
, (3) the time to
expiration of the option is within (including) 10 to 60 trading days, and (4) from the options
written on same stock satisfying conditions (1)-(3) we retain those that have more than 2 strike
prices for at least one maturity. For options on same underlying that meet the criteria above we
first choose the maturity with the highest number of strikes; if options of different maturities
have the same number of strike prices, we then choose the maturity with the highest trading
volume to ensure that we include the most actively traded options. The final sample for stock
options consists of 132,668 stock end-of-month days from 4,872 different firms, and the number
of stocks in each month increases from 90 in J anuary 1990 to 1470 in September 2008.
2.2 Option trading and price variables
For each month t in the sample, we use the CBOE volume data to compute a measure
that we call the positive-exposure demand for stock options (PS
t
) and positive-exposure
demand for SP500 index options (PI
t
). PS
t
and PI
t
measure the newly established net
option positions that have p iv erlying and are computed as follows: osit e exposure to the und
PS
t
= PS_C
t
+PS_P
t
, where (10.1)

PS_C
t
= log _BuyColl
t,:,1,K

K 1 :
_ - log _ScllColl
t,:,1,K

K 1 :
_

PS_P
t
= log_ScllPut
t,:,1,K

K 1 :
_ - log _BuyPut
t,:,1,K

K 1 :
_

6
For a call, the ask price is not less than S-K-PV(D), and the bid price is not larger than S; for a put, the ask price is
not less than K-S+PV(D), and the bid price is not larger than K. For the European SPX options, we adjust the
arbitrage bound by replacing K with Ke
-rT
.
14

PI
t
= PI_C
t
+SI_P
t
, where (10.2)

PI_C
t
= log_BuyColl
t,:,1,K
SPX
K 1 :
_ - log _ScllColl
t,:,1,K
SPX
K 1 :
_

PI_P
t
= log_ScllPut
t,:,1,K
SPX
K 1 :
_ - log _BuyPut
t,:,1,K
SPX
K 1 :
_

where i indexes stocks having traded options in month t, is the th trading day in month t, I
indexes the option maturities, and K indexes strike prices. BuyColl
t,:,1,K

is the number of call

contracts open purchased by non-market maker investors in month t on stock i across all
maturities and strike prices, and the remaining terms ScllColl
t,:,1,K

, BuyPut
t,:,1,K

, and
ScllPut
t,:,1,K

, are computed in an analogous manner.

7
We do not use delta adjusted volume
because (1)sentiment driven investors are more attracted to OTM options due to their high
liquidity and leverage, and (2) OTM index puts are the most heavily traded index options.
The measures of PDS and PDI are simple measures of the net demand for option
positions that have positive exposure to the underlying stocks and SP500 index, respectively.
The PDS and PDI are different from the proxies for option demand examined in Bollen and
Whaley (2004) and Grleanu, Pedersen, and Poteshman (2009), where the option demand is
measured as the difference between buy and sell option volume or open interest. PDS and PDI
have positive exposure to the underlying, while the option demand measures in above studies

7
We do not use close volume because investors might close existing option positions not solely based on their
perceptions about the future. Other conditions, such as past performance of the position, time to expiration and
margin requirements, can also cause investors to close a position. When the option expiration day is approaching,
many investors close their stock option positions to avoid physical delivery of the underlying. Margin requirements
might also force investors to close short positions, even though they would otherwise be unwilling to do so.
15








have positive exposure to volatility. We use PDS and PDI instead of option demand because
sentiment is more likely to drive investors to speculate on the direction of underlying stock price
movements.
The primary measure we use to examine the relation between sentiment and option prices
is the slope of the implied volatility smile, i.e., the implied volatility difference between OTM
calls and OTM puts.
8
For individual stock options, the slope measure is the average slope across
all stocks. For index options, the slope measure is the slope of the implied volatility smile of
SP500 index options. Specifically, the slope measures for stock options (SlopeS
t
) and index
options (SlopeI
t
) in month t are given by:
SlopcS
t
=
1
N
t
_II_0IHcoll
t,1,K

K
-II_0IHput
t,1,K

K
_
N
t

(11.1)

SlopcI
t
= II_0IHcoll
t,1,K
SPX
K
-II_0IHput
t,1,K
SPX
,
K
(11.2)

where N
t
is the number of stocks having traded OTM calls and puts on the last trading day of
month t, II_0IHcoll
t,1,K

and II_0IHput
t,1,K

are the implied volatilities of OTM calls and
OTM puts, respectively, with maturity T and underlying stock i. The above slope measures are
similar to the ones used by Han (2008), and are essentially equivalent to the risk neutral
skewness embedded in option prices (Bakshi, Kapadia and Madan (2003)). We use the slope of
the volatility smile instead of model free risk neutral skewness developed in Bakshi, Kapadia and

8
We consider options with u.12S <
C
u.S7S (or -u.S7S <
P
-u.12S) are OTM calls (or OTM puts). When
computing the option delta, i.e.,
C
and
P
, we estimate volatility using the previous 60 trading days stock or index
returns. We obtain similar results by using the implied volatilities of the options to compute delta or by using K/S to
classify moneyness.
16

Madan (2003) because most stocks do not have a sufficient number of strike prices to generate
the integral necessary to compute the risk-neutral skewness; the median number of strike prices
for optionable stocks in our sample is only three.
2.3 Sentiment Measures
The main measure of sentiment here is the monthly index of Consumer Sentiment (CS)
collected by University of Michigan. We view CS is likely to be a proxy for systematic
behavioral bias of noise traders because it is based on a survey of households perceptions about
current and future financial conditions. Lemmon and Portniaguina (2006) find that the level of
consumer sentiment predicts returns on small stocks and those with low institutional ownership.
In the main test, we adjust CS after with a set of macroeconomic variables including credit
spread, unemployment rate, and corporation productivity.
In addition to the direct sentiment measures, we also use one month lagged market
returns to capture the idea that changes in stock valuations are likely to be associated with
hedging demand for index put and with the potential for overreaction by unsophisticated
traders.
9
Consistent with the latter view, Lakonishok, Shleifer, and Vishny (1994) argue that the
value premium in stock returns arises from investors over-extrapolating past performance.

3. I ndex and stock option trading
3.1 Summary statistics

9
In addition, the measures of investor sentiment are also likely in part driven by past stock returns and we wish to
separate the component on sentiment that is unrelated to market returns from sentiment associated with changes in
stock market valuations.
17








Table 1 presents summary statistics for the main variables. The level and monthly change
of positive-exposure demand for stock options (PDS and dPDS) are close to zero on average.
The level (PDS) has high autocorrelation, while the change (dPDS) has no significant
autocorrelation. The positive-exposure demand for stock calls (PDS_C) is positive, while the
positive-exposure demand for stock puts (PDS_P) is negative, implying that the average stock
option open buy volume exceeds the open sell volume in both calls and puts. The positive-
exposure demand for SP500 index options (PDI, PDI_C and PDI_P) are all negative, especially
for puts (PDI_P), suggesting put purchases comprise the bulk of index option trading (Bollen
and Whaley (2004)). The slope of the volatility smile for stock options (SlopeS) is -204 basis
points, indicating that the implied volatility of out-of-the-money calls lies below that of out-of-
the-money puts on average. The average slope of the IVF for index options (SlopeI) is -415
basis points, which is much more negative than SlopeS.
Insert Table 1 around here

The Michigan consumer sentiment index (CS) has a mean value 90.19 and strong auto
correlation (0.93), while its monthly change dCS has a mean close to zero and near zero
autocorrelation. CS is the residuals after we regress CS on credit spread, unemployment rate
and corporation productivity; dCS is the residuals after we regress dCS on changes of those
macro-economic variables. Similar to the raw measures, CS has high autocorrelation, while
dCS has zero autocorrelation. In the main test, we use macroeconomic factor adjusted consumer
sentiment. Table 1 also reports summary statistics for the realized volatility for stocks and the
18








S&P500 index over the remaining life of the option contracts (o
S
or o
I
), and the monthly excess
return on the value-weighted CRSP index (Rm).
Table 2 reports the correlation coefficients for the main variables. The positive-exposure
demand (PD) for stock calls and puts, PDS_C and PDS_P, are positively correlated with each
other, and the PD for index calls, PDI_C, is positively correlated with PDS and PDS_P. In
contrast, the PD for index puts, PDI_P, is uncorrelated with PDS, PDS_C or PDS_P. These
correlations suggest PDI_P is driven by different forces from those that influence PDS_C,
PDS_P and PDI_C. The PD for stock options (PDS) is positively correlated with the slope of
the stock implied volatility smile (SlopeS) and with macro-economic factor adjusted consumer
sentiment (CS) and lagged market risk premium (Rm
-1
). In contrast, the PD for index puts
(PDI_P) has either negative or near zero correlations with these variables. The slope of stock
option smile, SlopeS, is positively correlated with both the levels and changes of the consumer
sentiment and lagged market returns. In contrast, the slope of the SP500 index option smile,
SlopeI, is negatively associated with CS, and exhibits a small positive correlation with dCS and
Rm
-1
. These correlation coefficients provide preliminary evidence consistent with the view that
consumer sentiment is positively associated with the demand for options that increases investors
exposures to the underlying stock and with the slope of the implied volatility smile for stock
options, but that sentiment exhibits a different relation with the demand and pricing of index
options.
Insert Table 2 around here

19








Figure 2 plots the time series of PDS, PDI, the level of the S&P 500 index, and the raw
measure of consumer sentiment. The figure shows that investors tend to increase their exposure
to individual stocks through the options market (i.e buy stock calls and sell stock puts) in periods
of high market returns and when sentiment is high. The correlation of PDS with the level of
consumer sentiment is particularly evident. In contrast, there is some evidence that investors
reduce their exposure to the index when market returns have been high. The correlations
between the demand for index options and the sentiment measures are less evident.
Insert Figure 2 around here

3.2 Option trading behavior of different investor types
A number of studies associate noise traders with small unsophisticated individual
investors, while institutional investors are generally assumed to act as rational arbitrageurs (Lee,
Shleifer, and Thaler (1991), Kumar and Lee (2006), Lemmon and Portniaguina (2006)). To
examine the trading behavior of different investors in the options markets, we use non-market
maker option volume obtained from the CBOE for the time period from 1990 to 2008. The
Option Clearing Corporation divides non-market maker option transactions into trades from firm
proprietary traders and trades from public customers. An example of a firm proprietary trader
would be an employee of Goldman Sachs trading for the banks own account. From 1990 to
2001, the CBOE further subdivides the public customer data into orders that originated from
customers of discount brokerages, customers of full-service brokerages, and other public
customers. Clients of brokerage firms such as E-Trade are an example of discount brokerage
20








customers, and clients of Merrill Lynch are an example of Full-service brokerage customers. For
the remaining part of the sample period from 2002 to 2008, the CBOE changed its classification
scheme and subdivides public customer volumes into volumes associated with small, medium
and large trades corresponding to orders for less than 100 contracts, between 100 and 199
contracts, and larger than 199 contracts, respectively.
Among public customers, we consider discount brokerage customer or small size trade as
most likely to be associated with unsophisticated investors, and full service customer or large
trade size as more likely to be associated with relatively more sophisticated investors (for
example, hedge funds trade through full service brokerages). Further evidence that discount
brokerage customers are less sophisticated is provided in Pan and Poteshman (2005), who show
that full-service brokerage customers and other public customers have a greater propensity than
discount brokerage option traders to open purchased call (put) positions before stock price
increases (decreases). However, it is worthy to note that some investors in full service category
are also individual investors and subject to irrational behavioral, as shown in Poteshman and
Serbin (2003), customers of full-service brokers also engage irrational early exercise of
American options.
Figure 3 depicts the monthly percentage of total non-market maker volume attributable to
each class of investors. The percentage volume is computed as the sum of buy and sell option
volume for a particular type of investor divided by the sum of buy and sell volume of all non-
market maker investors. Figure 3 shows that discount/small public customers trade stock options
much more actively than index options, while more sophisticated public customers are active
21








traders of both stock and index options. Trading generated from discount brokerage customers
constitutes 14% of total non-market maker trading of stock options, but only 2% of SPX index
options. Trading from small trades shows the same patter, small trades constitute 32% of trading
of stock options, but only 4% of SPX index options. Full service customers make up around 60%
of both stock and index trading, and large trades make up 41% of stock option trading and 53%
of index option.
Insert Figure 3 around here

4. Results
In this section we examine how consumer sentiment and lagged market returns are
related to option demand. We then investigate the associations of sentiment and past return with
the pricing of stock and index options and the profitability of a trading strategy. We also present
several robustness tests and conclude with an examination of the cross-sectional effects of
sentiment on positive-exposure demand and price of stock options and stock option prices.
4.1. Determinants of stock and index option trading
The first part of our empirical analysis investigates the determinants of positive-exposure
demand for stock and index options. Based on our prior analysis, we argue that the positive
exposure demand for index options (PDI) is more likely to be driven by rational investors. In
contrast, we argue that the positive exposure demand for stock options (PDS) is more likely to be
driven by sentiment of noise trader to speculate on the future direction of stock prices. To
22

investigate how the demand for options is influenced by sentiment, we estimate the following
time-series regression specifications:
PS = o
S
+b
S
Scnt +c
S
Rm +J
S
Rm
t
+
S
P
1
+
PI
t
= o
I
+b
I
Scnt
t
+c
I
Rm
t-1
+J
I
Rm
t
+
I
PI
t-1
+e
t
I
, (12.2)
t t t-1
S
t-
e
t
S
(12.1)


where PDS
t
and PDI
t
are computed from Eq.(10.1-10.2). In the analysis, we also break down
PDS
t
and PDI
t
into the components associated with call and put options separately. Because PDS
and PDI have high autocorrelations, we also use their monthly changes in some model
specifications. Sent
t
is sentiment measured either by the level of Michgan Consumer Sentiment
adjusted for macroeconomic factors (CS) or the change of consumer sentiment adjusted for
change of macroeconomic factors (dCS). The lagged market return, Rm
-1
, is used to examine
how option demand responds to past market movements. The regressions also include
contemporaneous market returns, Rm, and the lagged dependent variable as controls.
10

The results are presented in Table 3. When the dependent variable is the level of positive-
exposure demand for stock options (PDS), the coefficient estimates on the level (CS) and the
change (dCS) of consumer sentiment and market returns are all positive and statistically
significant. The estimates on lagged market returns are approximately twice as large as those on
contemporaneous market returns. When the dependent variable is the monthly change of
positive-exposure demand for stock options (dPDS), the coefficient estimates on dCS and the
lagged market return remain positive and statistically significant. In economic terms, a one
standard deviation change in dCS is associated with a three unit change in dPDS, amounting to

10
We also try the specifications that include underlying volatilities and bull-bear sentiment, the coefficient estimates
on these variables are not statistically different from zero.
23








16% of the unconditional standard deviation of dPDS. And a one standard deviation change in
the lagged market return is associated with a eight unit change in dPDS, amounting to more than
one third of standard deviation of dPDS.
Insert Table 3 around here

Panels C and D present the results based on the positive-exposure demand for stock
options from puts (dPDS_P) and calls (dPDS_C) separately. The results show that changes in
consumer sentiment are more strongly related to dPDS_P than to dPDS_C. For put demand, the
coefficient estimate on dCS is 0.53 with a t-statistic of 2.32, while for call demand, the
coefficient estimate is 0.34 with a t-statistic of 1.39. In addition, dPDS_P and dPDS_C are both
positively related to lagged market returns, indicating that investors increase their exposure to
stocks by selling puts and buying calls after high market returns.
In contrast, as seen in the right hand side of Panel A, the positive-exposure demand for
index options (PDI) is not related to either sentiment or lagged market returns; all the estimates
of coefficients on consumer sentiment measures and past market returns are insignificant when
PDI or dPDI is the dependent variable. Breaking down dPDI into the demands from puts and
calls separately shows the similar pattern.
The results presented in Table 3 confirm the visual observations in Figure 2. The
positive-exposure demand for stock options and index options do not follow the same pattern.
PDS is driven by sentiment and prior market returns. When consumer sentiment and past returns
are high, investors increase their exposures to individual stocks by purchasing calls and selling
24








puts. On the other hand, the demand for SPX index options that increase exposure to the index is
not related to investor sentiment or past market returns.
Referring back to Figure 3, a significant portion of the volume in stock option trading is
attributable to discount brokerage customers/small trades, while only a small fraction of the
volume in index options is generated from this group of investors. These figures suggest that
relatively unsophisticated investors are important participants in the stock option market, but not
in the index option market. If unsophisticated investors are more prone to be sentiment driven,
then we expect that their demands for options that increase their exposure to underlying stocks
will be more sensitive to changes in sentiment and past returns compared to the demands of other
investors.
Table 4 reports the results where the dependent variables are the monthly changes of
positive-exposure demand for stock or index options from different types of investors. Panel A
is for the period 1990-2001 and panel B is for the period 2001 to 2008, corresponding to the
change in the reporting of trader types by the CBOE. When the dependent variable is dPDS, the
coefficient estimates on dCS is positive and statistically significant for discount, small and
medium investors. The estimates on lagged market returns are positive and statistically
significant for discount and small investors, and remain positive but insignificant for full, other,
and medium investors. While the coefficient estimates on lagged returns are negative for firm
proprietary.
When the dependent variable is dPDI, none of the coefficient estimates on dCS are
statistically significant. The estimates on lagged returns are positive but not significant for
25








discount and small investors, and remain negative and statistically significant for firm
proprietary traders.
Insert Table 4 around here
Overall, the results suggest that less sophisticated investors (proxied by discount and
brokerage customers and small trade size) in particular tend to increase their exposures to
individual stocks through options trading when sentiment is high and following high past returns.
In contrast, firm proprietary traders trades appear to act more like market makers and take the
opposite side of these trades.
4.2. Sentiment and Option Prices
The previous section documents that the consumer sentiment and past market returns are
positively related to the positive-exposure demand for stock options, but are generally unrelated
to positive-exposure demand for index options. To the extent that market-makers in options
cannot perfectly and costlessly hedge their positions, supply curves for options become upward
sloping. In this case, systematic demand imbalances generated by the trades of end users of
options can affect option prices (Garleneau, Pedersen, and Poteshman (2007)). If sentiment and
market returns reflect changes in the aggregate demand for stock options as indicated by our
results in the last section, then we expect that changes in these variables will also be reflected in
option prices.
Specifically, our prior results show that investors increase their exposures to underlying
stocks through the options market when sentiment and past market returns are high. Given the
fact that the volume of OTM options is far greater than that of ITM options, the results suggest
26

that demand for high strike options will be larger than demand for low strike options following
increases in sentiment or high market returns. Based on this argument, we expect the slope of
the IVF of stock options, measured as the implied volatility difference between OTM (high
strike) calls and OTM (low strike) puts, to be positively associated with sentiment and past
market returns.
11
In contrast, we expect sentiment to be unrelated to the prices of index options,
which, as we have shown, are largely immune from demand imbalances associated with changes
in aggregate sentiment.
On the contrary, if consumer sentiment and past returns are proxies for changes in
fundamentals such as jump or volatility risks, as shown in Section 1, the slopes of IVF of stock
and index options will respond to sentiment and lagged market return in similar ways.
The empirical specification used to investigate the impact of sentiment on option prices is
as follows:
t
S
t
t-
o cS
t
e
t
S
SlopcS = o +g
S
Scn
t
+b
S
Rm
1
+ q
S
Rm
t
+l
S
BB
t
+]
S
t
S
+k
S
Slop
-1
+ (1S.1)
SlopcI
t
= o
I
+g
I
Scnt
t
+b
I
Rm
t-1
+ q
I
Rm
t
+ l
I
BB
t
+]
I
o
t
I
+k
I
SlopcI
t-1
+e
t
I
, (1S.2)
where SlopeS
t
and SlopeI
t
are slope of IVF of stock and index options and are calculated based
on Eqs. (11.1) and (11.2), Sent
t
is sentiment measured either by Michgan index of Consumer
Sentiment adjusted for macroeconomic factors (CS) or monthly change of Consumer Sentiment
adjusted for change of macroeconomic factors (dCS). Rm
t-1
and Rm
t
are previous and
contemporaneous monthly market risk premium. If sentiment and past market returns affect

11
Note that to the extent that the sentiment related demands for purchasing calls and selling puts are roughly equal,
there will be no effect of sentiment on the prices of at-the-money options. In unreported results this is indeed what
we find.
27

option prices through changes in demand, then the coefficients g

S
and b
S
will be positive and
significant, and the coefficient g
I
and b
I
will be insignificant. Alternatively, if sentiment and
past returns instead influence option prices because they proxies for changes in risk preferences
or fundamentals, as shown in Section 1, the coefficients g
S
and g
I
, or b
S
and b
I
will be similar
in sign and significance, as innovations in risk or fundamentals should affect prices of both index
and stock options in similar ways.
The regressions also control for a number of other factors related to the slope of the
volatility smile. Han (2008) finds that institutional investor sentiment proxied by the level of
bull-bear spread (BB) is related to the prices of SPX index options. Li and Pearson (2006),
Dennis and Mayhew (2002), and Han (2008) find that volatility is negatively related to the slope
of the volatility smile. We control for volatility using the average realized volatility of the
underlying stock or index returns measured over the remaining life of the option contracts (o
S
or
o
I
).
12
We also control for Rm, the contemporaneous market returns, because Amin, Coval and
Seyhun (2004) document that S&P 100 index call (put) prices are overvalued following large
upside (downside) market movements. Finally, we include the past months slope measure to
control for serial dependence in the slope.
Table 5 reports the results. For stock options (Panel A), the coefficient estimates on CS,
dCS and lagged market returns are all positive and significant. In economic terms, a one
standard deviation increase of dCS is associated with a 42 basis point increase in the slope of the
implied volatility function for stock options (SlopeS), a magnitude equivalent to 15% of the

28

12
For individual stock options, we average the realized volatility across options in the sample. Similar results
obtained if we replace o
I
with VIX index.







unconditional standard deviation of SlopeS. And a one standard deviation change in lagged
market returns is associated with a 35.5 basis point increase in the slope of the implied volatility
of stock options.
The results for index options (Panel B) exhibit a different pattern. None of the coefficient
estimates on the consumer sentiment or lagged market returns are statistically significant. These
findings show that sentiment affects stock options and index option prices in a manner consistent
with the idea that fluctuations in speculative demand driven by changes in aggregate sentiment
affect the prices of options on individual stocks but are unrelated to prices of index options.
As seen in Table 5, the coefficient estimate on BB (a measure of institutional investor
sentiment) is positive and significantly related to the slope of IVF for index options, which is
consistent with the empirical findings of Han (2008). The coefficient estimates on BB are
positive but not statistically significant for stock options. The coefficient estimates on realized
volatility (o
S
or o
I
) are negative in most specifications. The negative relation between volatility
and slope is consistent with the theoretical prediction of Bakshi, Kapadia and Madan (2003), and
with the empirical findings of Li and Pearson (2006). There is no consistent relation between
contemporaneous market returns (Rm) and the slope of the volatility smile for either stock or
index options.
Insert Table 5 around Here



29








4.3. Trading Strategy
The results in previous section suggests that stock OTM calls are more (less) expensive
than OTM puts when sentiment and lagged market returns are high (low). To provide further
evidence on how sentiment and past returns affect the relative prices of options, we compute
returns from a trading strategy that trades calls and puts conditional on sentiment and lagged
returns. In particular, we sell OTM calls and buy OTM puts in last three trading days of the
month if change of consumer confidence (dCS) in that month is larger than 1 or 2 points and the
previous months market risk premium minus 0.5% (Rm
-1
-0.5%) is larger than 1% or 2%, and we
buy OTM calls and sell OTM puts when dCS is less than -1 or -2 and Rm
-1
-0.5% is less than -1%
or -2%. We choose 0.5% because average market risk premium is around 0.5% per month. In
selecting the OTM call and put pairs for each underlying stock, we require options to have: (i)
same maturity of less than 60 trading days; (ii) non-zero trading volume; (iii) larger than $0.125
bid price, and (iv) bid ask spread below 15% of the mid price. If more than one call or put
satisfy above conditions for a pair, we choose the call (or put) with the largest trading volume.
For each call and put pair, we then compute the returns from holding the options to maturity with
and without delta hedging. The return without delta hedging is the profit of holding the position
to maturity scaled by the average call and put prices. The return with delta hedging is the
proceeds from the delta hedged position divided by the average call and put prices. To estimate
delta, we use both historical volatility based on daily returns of the underlying stock in previous
60 trading days and realized volatility based on the daily returns during the remaining life of the
option contracts. The results are reported in Table 6.
30








As seen in the table 6, all of the strategies yield significant positive abnormal returns
before accounting for option transactions costs. For example, the strategy that conditions
|dCS|>1, and |Rm-0.5|>1% has returns of 12.42% before delta hedging and returns of 6.36% after
delta hedging based on realized volatility. The returns increase further to 35.72% and 20.32%,
respectively, when we condition on |dCS|>2, and |Rm-0.5|>2%. Even after accounting for
transactions costs, all of the unhedged strategies and those of the hedged strategies conditioned
on |Rm-0.5|>2% yield positive and statistically significant returns. For example, the strategy that
conditions on |dCS|>2, and |Rm-0.5|>2% yields returns of 32.08% before delta hedging and
10.50% after delta hedging based on realized volatility. Finally, Table 6 also shows that the
average delta hedged return with realized volatility is higher than that with historical volatility.
This result suggests that mismeasurement of volatility does not upward bias returns of the delta
hedged strategies.
Insert Table 6 Here
To summarize, the results from the trading strategies show that positive returns are
generated by strategies that sell options that end users demand. The analysis provides additional
evidence that sentiment and past returns alter the time-series variation in the slope of the implied
volatility function of stock options, reflect changes in relative option prices as predicted by the
demand-based view of option pricing.
4.4. Robustness Tests
Our conclusion that sentiment and past returns as proxy for behavioral bias impact prices
of stock options relies on the view that time series variations in IVF of stock and index options
31








are driven by same fundamentals. It is possible that some factors influence prices of options on
stocks differently from options on index. For example, stock options are less liquid than index
options. However, for our findings to be driven by liquidity, it would need to be the case that
liquidity is associated with trading and slope of IVF of stock options. To examine if it is the case,
we use liquidity factor developed in Pastor and Stambaugh (2003) as a control and re-estimate
the coefficients of sentiment and past market returns.
Another alternative explanation is that sentiments or market returns are correlated proxies
for future physical jump information in individual stocks which does not captured in prices of
index options. To investigate this hypothesis, we re-estimate the regressions controlling for
future realized return skewness (Skew) as a proxy for physical jump information. Future
skewness is a reasonable proxy for physical jumps, because a stock with high return jumps must
also exhibit high return skewness. We estimate Skew using daily returns from one trading day
after when we record the option price, to the last trading day of the following month.
Table 7 explores whether liquidity or skewness information can explain the relations
between sentiment (lagged returns) and trading or pricing of stock options, and shows that
neither liquidity nor future skewnss has power of explaining the positive exposure demand for
stock options (dPDS), and slope of stock option IVF (SlopeS). The coefficient estimates on
sentiment and lagged market returns remain statistically significant when liquidity or realized
skewness is included in the regressions.
Insert Table 7 Here

32








4.5. Sentiment and Lagged Returns versus PDS
If option demand is the only channel through which sentiment and lagged returns
influence option prices, then after controlling for PDS, sentiment and lagged returns should have
little power to explain the slope of the implied volatility function. Table 8 reports the results of
this investigation with SlopeS as the dependent variable. The coefficient estimate on PDS is
positive statistically significant, indicating that demand fluctuations have a direct effect on
option prices in the manner predicted. Nevertheless, after controlling for demand, sentiment
continues to have some explanatory power for option prices. For example, after controlling for
PDS, the coefficient estimate on dCS is 8.35 (t-statistic =2.82), while, in the absence of PDS,
(See Table 5, Panel A), the coefficient estimate on dCS is 10.23 (t-statistic =3.27). These
results suggest that although consumer sentiment does affect relative option prices through
demand, it is not the only channel. In contrast, adding PDS to the regression wipes out the
predictive power of lagged market returns.
13

Insert Table 8 around here

3.6 Cross-Sectional Analysis
Finally, we investigate the relation between sentiment and positive-exposure demand for
stock options (PDS) and the slope of the implied volatility function (SlopeS) for stocks with
different characteristics. If the positive relationships of sentiment with PDS and SlopeS arise
from demand imbalances driven by speculation, we should find that the association between

13
The results are similar after we replace PDS with the net demand for high strike options (OTM calls and
ITM outs) minus the net demand for low strike options (OTM puts and ITM calls).
33








sentiment and the slope of the IVF is stronger for stocks in which trading by investors who are
prone to be sentiment driven is more concentrated and in stocks where market-makers face
higher arbitrage and hedging costs. As proxies for the costs of arbitrage we use volatility and the
volatility of volatility.
We estimate individual trading activity on options on a particular stock by the total trading
volume of discount investors/small trade sizes divided by the trading volume of all non-market
makers. For each month, we estimate volatility and its volatility with daily returns, where the
volatility of volatility is measured as the standard deviation of daily absolute returns. We first
sort stocks into quintiles based on the characteristic of interest, and then compute PDS and the
average of SlopeS across stocks in each quintile for every month. We then sort months into
quintiles based on the level of the consumer sentiment and compare PDS or SlopeS during
periods of high and low sentiment across stock characteristic quintiles.
The results are reported in Table 9. As seen in Panel A, the difference in PDS during
periods of high and low sentiment is 34.46 units for stocks with the lowest concentration of
trading by individual investors and 82.49 units for stocks in the highest quintile of individual
investor trading, and the difference is statistically significant. Consistent with these differences
in demand, the right hand side of Panel A also shows a similar effect on SlopeS; the difference in
SlopeS between high and low sentiment periods is 366.70 basis points for stocks in the lowest
quintile of individual investor trading, and 528.05 basis points for stocks in the highest quintile.
The difference is statistically significant. Similar patterns are documented for stocks sorted on
the basis of volatility, and the volatility of volatility, both of which proxy for differences in
34








35

market maker-hedging costs. In both cases there is a positive association between the proxies for
hedging costs and the effects of sentiment on speculative demand and the slope of the IVF in the
predicted direction.
Insert Table 9 Here
5. Conclusion

We show that the demand for stock option positions that increase exposure to the
underlying is positively related to measures of investor sentiment and past market returns, while
the demand for index options is invariant to sentiment and returns. These differences in trading
patterns are reflected in differences in the composition of traders in the different types of
options---Options on individual stocks are actively traded by unsophisticated investors who
appear to use options largely to speculate on future stock-price movements, while trades in index
options are more often motivated by hedging demands of sophisticated investors. Consistent
with a demand based view of option pricing, we find that sentiment is related to time-series
variation in the slope of the implied volatility smile of stock options, but has little impact on the
prices of index options. The pricing impact is more pronounced in options with higher
concentration of speculative trading, higher stock return volatility, and those with higher
volatility of volatility. Our results provide new evidence that sentiment and lagged market
returns as behavioral biases affect the demand for and prices of securities traded actively by
individual investors, but has little effect on the prices of securities in which demand is driven by
hedging motives from rational investors.







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38








39

Table 1 Summary Statistics
Mean Std Min Max Auto
Positive-exposure demand for stock options (PDS) -2.61 34.05 -128.49 82.57 0.79
Change of PDS (dPDS) 0.15 21.71 -54.70 96.45 -0.05
PDS from call (PDS_C) 13.73 22.57 -35.79 73.77 0.75
Change of PDS_C (dPDS_C) 0.21 15.57 -75.53 62.65 -0.29
PDS from put (PDS_P) -16.34 24.86 -112.88 41.82 0.76
Change of PDS_P (dPDS_P) -0.06 16.54 -68.89 73.09 -0.15
Positive-exposure demand for index options (PDI) -37.35 22.00 -134.14 1.32 0.61
Change of PDI (dPDI) 0.25 18.53 -64.41 60.88 -0.35
PDI from call (PDI_C) -8.30 16.05 -74.46 21.17 0.61
Change of PDI_C (dPDI_C) 0.11 13.41 -46.57 44.14 -0.42
PDI from put (PDI_P) -29.04 13.56 -68.56 0.94 0.49
Change of PDI_P (dPDI_P) 0.14 12.45 -52.80 51.26 -0.44
Slope of smile for stock options (SlopeS) (bp) -204.15 269.12 -1122.39 773.42 0.29
Slope of smile for index options (SlopeI)( bp) -415.90 248.34 -1611.04 364.57 0.58
Consumer sentiment (CS) 90.19 11.33 56.40 112.00 0.93
Change of CS (dCS) -0.10 4.09 -12.20 17.30 -0.01
Consumer sentiment macro adjusted (CS) 3.36 23.28 -45.37 49.90 0.97
Change of CS macro adjusted (dCS) -0.10 4.10 -12.29 16.97 -0.00
Bull-bear spread (BB) 14.72 14.55 -26.70 41.05 0.71
Volatility of Stocks (
S
)(bp) 4709.31 1556.57 2501.69 11801.61 0.83
Volatility of SP500 index (
I
) (bp) 1481.57 726.03 486.62 5419.19 0.51
Monthly market excess return Rm 0.48 4.12 -16.20 10.30 0.02
The positive-exposure demand for stock options (PDS) is the monthly sum of the non-market maker
open buy call and sell put volumes minus the sum of open sell call and buy put volumes across all
stock options, where volumes are in logarithm. PDS_C or PDS_P is PDS computed form stock calls
or stock puts only. PDI, PDI_C and PDI_P are similar variables for SP500 index options. SlopeS is
the cross sectional average slope of IVF for stock options, computed as the difference between
implied volatilities of OTM calls and implied volatilities of OTM puts. SlopeI is the slope of implied
volatility of S&P500 index options. Consumer sentiment (CS) is based on monthly household survey
conducted by the University of Michigan. dCS is its monthly change. CS and dCS are the maro-
economic factors adjusted CS and dCS. Variables are for the period of J anuary 1990 to September
2008.







Table 2 Correlation Coefficients
PDS PDS_C PDS_P PDI PDI_C PDI_P SlopeS SlopeI CS dCS BB
S

I
PDS_C 0.74
PDS_P 0.79 0.32
PDI 0.11 -0.08 0.24
PDI_C 0.18 -0.13 0.38 0.80
PDI_P -0.03 0.02 -0.06 0.68 0.11
SlopeS 0.42 0.36 0.29 0.02 0.07 -0.04
SlopeI 0.12 0.14 0.04 -0.15 -0.10 -0.13 0.15
CS 0.46 0.12 0.56 0.13 0.20 -0.06 0.44 -0.19
dCS 0.17 0.07 0.19 -0.01 0.02 -0.03 0.16 0.06 0.22
BB 0.12 0.08 0.23 0.30 0.23 0.22 0.10 0.16 0.19 -0.05

S
0.08 -0.07 0.17 0.07 0.28 -0.17 0.19 -0.41 0.49 -0.09 0.05

I
-0.09 -0.15 0.00 0.13 0.19 -0.02 -0.03 -0.51 0.20 -0.16 0.18 0.66
Rm
-1
0.39 0.36 0.27 0.02 -0.04 0.08 0.18 0.06 0.12 0.28 0.06 -0.17 -0.21

PDS is the positive-exposure demand for stock options, measured as the monthly sum of the non-market maker open buy call and sell put
volumes minus the sum of open sell call and buy put volumes across all stock options. PDS_C and PDS_P arePDS from stock calls and
stock puts. PDI, PDI_C and PDI_P are similar variables for SP500 index options. SlopeS is the cross sectional average slope of IVF for
stock options, computed as the difference between implied volatilities of OTM calls and implied volatilities of OTM puts. SlopeI is the
slope of implied volatility of S&P500 index options. CS and dCS are level and change of Consumer sentiment adjusted for macro-
economic factors. BB is bull bear spread, a proxy for institutional sentiment.
S
and
I
are realized volatility for stocks and SPX. Rm
-1
is
previous month market risk premium. Variables are monthly and for the period of J anuary 1990 to September 2008.
40








Table 3 Determinants of positive-exposure demand for stock options (PDS) and
positive-exposure demand for index options (PDI )
Sent Sent Rm
-1
Rm Lag obs/R
2
Sent Rm
-1
Rm Lag obs/R
2

Panel A Positive-exposure demand
Dependent: PDS (stocks) Dependent: PDI (S&P500 index)
CS 0.26 2.05 0.82 0.71 224 0.11 0.06 -0.22 0.61 224
(2.38) (8.20) (3.54) (6.40) 0.71 (1.05) (0.16) (-0.61) (2.98) 0.38
dCS 0.69 1.93 0.79 0.75 224 0.02 0.10 -0.20 0.62 224
(2.41) (7.69) (3.24) (6.95) 0.71 (0.08) (0.29) (-0.56) (2.82) 0.37
Panel B Change of positive-exposure demand
Dependent: change of PDS (dPDS) Dependent: change of PDI (dPDI)
dCS 0.75 2.02 0.96 -0.24 224 -0.05 0.11 -0.09 -0.34 224
(2.56) (7.18) (3.47) (-1.65) 0.27 (-0.11) (0.32) (-0.26) (-1.59) 0.10
Panel C Change of positive exposure demand for puts
Dependent: change of PDS_P (dPDS_P) Dependent: change of PDI_P (dPDI_P)
dCS 0.53 0.84 0.84 -0.33 224 0.02 0.22 -0.37 -0.47 224
(2.32) (4.09) (3.94) (-1.84) 0.20 (0.09) (1.04) (-1.63) (-2.06) 0.23
Panel D Change of positive exposure demand for calls
Dependent: change of PDS_C (dPDS_C) Dependent: change of PDI_C (dPDI_C)
dCS 0.34 1.29 0.14 -0.38 224 0.09 -0.15 0.31 -0.39 224
(1.39) (7.64) (0.77) (-2.07) 0.27 (0.26) (-0.68) (1.36) (-2.13) 0.15

PDS is positive exposure demand for stock options, measured as the sum of stock option open
buy call and sell put volume minus the sum of open buy put and sell call volume, dPDS is its
monthly changes, and dPDS_P or dPDS_C is the monthly change of PDS for stock calls or puts
only. PDI, dPDI, dPDI_P and dPDI_C are similar variables for S&P500 index options.
Sentiment (Sent) is either CS or dCS, the level or the change of Michigan consumer sentiment
adjusted for macro-economic factors. Lag is the lagged dependent variable. Rm
-1
and Rm are pre
and contemporaneous market premium. The parentheses contain Newey-West t-statistics that
correct for serial correlation and heteroscedasticity. Variables are monthly and for the period of
J anuary 1990 to September 2008.
41








Table 4 Determinants of positive exposure demand for stock (PDS) and index
options (PDI ) from different types of investors or trades
Dependent: dPDS (Stocks) Dependent: dPDI (S&P500 index)
dCS Rm
-1
Rm Lag dCS Rm
-1
Rm lag
Panel A: 1990 2001
Discount customers
2.29 3.78 2.63 -0.31 1.18 2.09 -1.75 -0.38
(2.91) (5.78) (3.58) (-1.21) (0.57) (1.82) (-1.28) (-1.65)
Full service customers
1.23 0.19 1.82 -0.29 0.54 -3.04 2.61 -0.36
(1.32) (0.31) (2.45) (-1.23) (0.22) (-1.61) (1.68) (-1.63)
Other customers
0.49 1.26 -4.02 -0.50 -0.38 2.14 -2.04 -0.45
(0.80) (1.60) (-6.21) (-2.46) (-0.34) (1.72) (-1.77) (-2.65)
Firm proprietary traders
-0.36 -2.77 0.26 -0.21 -0.45 -2.07 3.92 -0.49
(-0.59) (-5.01) (0.54) (-0.77) (-0.50) (-2.41) (4.19) (-2.83)
Panel B: 2002 2008
Small trades
1.29 4.04 0.06 -0.47 -0.20 0.62 0.04 -0.48
(2.09) (6.08) (0.08) (-2.17) (-0.61) (0.92) (0.07) (-1.68)
Medium trades
1.12 1.44 1.11 -0.37 0.74 -2.21 0.13 -0.30
(2.84) (1.21) (2.08) (-1.30) (0.80) (-2.49) (0.27) (-1.30)
Large trades
-0.76 -0.07 -3.48 -0.46 -0.48 0.69 -2.77 -0.37
(-1.47) (-0.07) (-4.35) (-1.74) (-0.63) (1.02) (-4.48) (-1.40)
Firm proprietary traders
0.39 -3.48 -0.05 -0.39 -0.68 -1.61 1.26 -0.28
(0.75) (-5.74) (-0.10) (-1.34) (-0.96) (-2.44) (1.81) (-1.16)

dPDS is the monthly change of positive exposure, and PDS is the sum of stock option open
buy call and sell put volumes minus the sum of open buy put and sell call volumes. dPDI is
the same variable for SPX index options. dCS is monthly change of Michigan consumer
sentiment adjusted for changes of macroeconomic factors. Rm
-1
and Rm are pre and
contemporaneous market returns, respectively. The parentheses contain t-statistics computed
from Newey-West standard errors correcting for heteroscedasticity and serial correlation.
42








Table 5 Slope of implied volatility smile for stock and index options

Panel A: Dependent: slope of stock option implied volatility smile (SlopeS)
CS' dCS' Rm-1 Rm BB
S
lag obs/R
2
7.28 8.34 -2.84 0.91 -0.02 0.38 224
(4.55) (2.27) (-0.51) (1.23) (-1.95) (3.41) 0.34
10.23 8.56 -2.65 1.71 0.00 0.50 224
(3.27) (2.59) (-0.46) (1.58) (0.40) (4.82) 0.30
Panel B: Dependent: slope of SPX option implied volatility smile (SlopeI )
CS' dCS' Rm-1 Rm BB
I
lag obs/R
2
-0.58 2.35 1.93 3.12 -0.12 0.54 224
(-0.65) (0.66) (0.84) (1.97) (-5.90) (6.00) 0.69
-2.23 2.76 2.08 2.92 -0.13 0.54 224
(-1.06) (0.76) (0.86) (1.91) (-5.88) (5.96) 0.69

SlopeS is the cross sectional average slope of IVF for stock options, computed as the
difference between implied volatilities of OTM calls and implied volatilities of OTM puts.
SlopeI is the slope of implied volatility of S&P500 index options. CS or dCS, is the level or
the change of Michigan consumer sentiment adjusted for macro-economic factors. Rm
-1
and
Rm are pre and contemporaneous market returns, respectively. BB is the bull bear spread.
Lag is the lagged dependent.
S
or
I
is the volatility of stocks or index. The parentheses
contain t-statistics computed from Newey-West standard errors that correct for serial
correlation and heteroscedasticity. The time period covers 1990 to September 2008.






43








Table 6 Returns of trading strategy on stock options

Return without delta hedge (%) Return with daily delta hedge (%)
Historical volatility Realized volatility
buy: mid
sell: mid
buy: ask
sell: bid
buy: mid
sell: mid
buy: ask
sell: bid
buy: mid
sell: mid
buy: ask
sell: bid
No. of
months/obs
|dCS|>1, |Rm
-1
-0.5|>1%
12.42 5.13 3.58 -6.32 6.36 -2.54 85
t-stats (2.79) (1.15) (1.88) (-3.32) (3.49) (-1.94) 43,916
|dCS|>1, | Rm
-1
-0.5|>2%
15.87 13.24 7.51 2.58 8.47 3.55 69
t-stats (6.12) (4.90) (5.78) (2.33) (6.06) (3.38) 34,373
|dCS|>2, | Rm
-1
-0.5|>1%
16.06 11.26 6.5 -3.34 7.92 -2.92 65
t-stats (3.18) (2.16) (3.01) (-1.54) (3.81) (-0.92) 34,471
|dCS|>2, | Rm
-1
-0.5|>2%
35.72 32.08 19.80 10.02 20.32 10.50 54
t-stats (6.31) (5.45) (6.00) (3.04) (6.61) (3.45) 27,218
A strategy of sell OTM calls and buy OTM puts in the end of the month is employed if dCS >1 or 2 and Rm
-1
-0.5 >1% or 2% , and a
strategy of buying OTM calls and selling OTM puts is employed if dCS<-1 or -2 and Rm
-1
-0.5<-1% or -2%. dCS is the monthly change of
consumer sentiment; Rm
-1
is pre month market risk premium. The time period is from J anuary 1990 to September 2008. T-stats adjusted for
cross correlation are in parentheses.

44








Table 7 Liquidity and skewness information interpretations for the role of
sentiment
dCS Liquidity Skew Rm
-1
Rm BB
S
Lag obs/R
2

Dependent: change of positive exposure demand for stock options (dPDS)
0.71 -3.85 2.02 0.96 -0.24 224
(2.51) (-0.14) (7.18) (2.17) (-4.92) 0.27
0.71 -8.85 2.06 0.97 -0.24 224
(2.52) (-1.00) (7.29) (3.55) (-4.43) 0.27
Dependent: Slope of stock option implied volatility smile (SlopeS)
9.98 -396.67 8.34 -2.30 1.87 0.00 0.50 224
(3.18) (-1.10) (2.46) (-0.39) (1.69) (0.40) (4.81) 0.29
10.03 212.61 6.93 -3.24 1.98 0.00 0.48 224
(3.21) (1.68) (1.97) (-0.56) (1.78) (0.20) (4.74) 0.30

dPDS is the monthly change of PDS, where PDS is the sum of stock option open buy call and sell
put volumes minus the sum of open buy put and sell call volumes. SlopeS is the cross sectional
average slope of IVF for stock options, computed as the difference between implied volatilities of
OTM calls and implied volatilities of OTM puts. dCS is the monthly changes of consumer
sentiment adjusted for changes in macroeconmic factors. Liquidity is traded liquidity factor used
in Pastor and Stambaugh (2003). Skew is the realized physical skewness of the underlying stocks
during the remaining life of option contracts. The parentheses contain t-statistics computed from
Newey-West (1997) standard errors that correct for serial correlation and heteroscedasticity. The
time period covers 1990 to September 2008.










45








Table 8 Slope of implied volatility smile for stock option: sentiment versus option
demand

PDS dCS Rm
-1
Rm BB
S
Lag obs/R
2

2.19 8.35 3.86 -3.61 1.13 0.00 0.43 225
(4.10) (2.82) (1.14) (-0.66) (0.87) (-0.13) (4.23) 0.33

The dependent is the slope of stock option implied volatility, computed as the cross sectional
average difference between implied volatility of OTM calls and implied volatility OTM puts.
PDS is the sum of stock option open buy call and sell put volumes minus the sum of open
buy put and sell call volumes, dCS is the monthly change of consumer sentiment adjusted
for change of macroeconomic factors, and Rm
-1
and Rm are pre and contemporaneous
monthly returns, respectively. The parentheses contain t-statistics computed from Newey-
West (1997) standard errors that correct for serial correlation and heteroscedasticity. The
time period covers J anuary 1990 to September 2008.
















46








Table 9 Cross sectional stock portfolio analysis
PDS SlopeS
Small 2 3 4 Large L-S Small 2 3 4 Large L-S
Panel A: Discount I nvestor Stock Option Trading Activity Measured by Open I nterest
Low CS -47.24 -47.21 -24.12 -11.39 -11.94 35.31 -455.37 -510.51 -413.69 -452.70 -427.17 28.20
High CS -12.79 13.24 23.81 45.85 70.56 83.34 -88.67 -166.82 -83.35 -40.53 100.88 189.55
H L 34.46 60.45 47.93 57.24 82.49 48.04 366.70 343.69 330.34 412.17 528.05 161.36
t-stats (3.21) (4.96) (4.97) (5.08) (5.78) (3.80) (6.45) (5.99) (5.29) (5.98) (7.20) (2.46)
Panel B: Stock Volatility
Low CS -23.85 -29.83 -20.01 -27.47 -8.69 15.16 -282.36 -382.13 -444.67 -426.19 -504.19 -221.83
High CS 0.80 13.78 30.80 35.54 37.11 36.31 -18.04 -61.62 -30.60 -92.08 45.73 63.77
H L 24.66 43.61 50.81 63.01 45.80 21.15 264.33 320.51 414.07 334.12 549.92 285.59
t-stats (2.42) (4.28) (4.70) (5.38) (4.85) (2.15) (5.71) (8.87) (12.24) (7.50) (8.95) (5.25)
Panel C: Volatility of Volatility
Low CS -30.89 -27.22 -19.39 -16.77 -6.36 24.52 -284.58 -288.22 -443.60 -400.70 -458.81 -174.23
High CS -5.42 17.67 26.62 37.23 40.14 45.56 -86.74 -57.61 -88.87 -35.04 10.02 96.76
H L 25.47 44.89 46.01 54.00 46.51 21.04 197.84 230.62 354.74 365.66 468.83 270.99
t-stats (3.11) (4.85) (4.89) (5.48) (5.59) (2.55) (3.55) (3.75) (4.33) (4.38) (5.19) (4.06)

PDS is the positive exposure demand for stock options, computed as the sum of open buy call and sell put volumes minus the sum of open buy put
and sell call volumes. SlopeS is the cross sectional average slope of IVF for stock options, computed as the difference between implied
volatilities of OTM calls and implied volatilities of OTM puts. CS is the consumer sentiment adjusted for macro-economic factors. The PDS
or SlopeS differences between high and low sentiment periods are reported on rows started with H L; their cross sectional difference between
stocks with large and small quintile categories are reported in column headed with L S. The parentheses contain t-statistics computed from
Newey-West (1997) standard errors that correct for serial correlation and heteroscedasticity.

47








48



0 0.1 0.2 0.3 0.4 0.5
-0.2
-0.15
-0.1
-0.05
0
J ump Size Premium
S
l
o
p
e

o
f

I
V
F
0 0.1 0.2 0.3 0.4 0.5
0.2
0.3
0.4
0.5
J ump Size Premium
I
V

o
f

A
T
M

o
p
t
i
o
n
s


index
stock
Figure 1 I VF of index and stock options with various jump and variance risk premia. Slope of IVF is the average IV of OTM
calls minus average IV of OTM puts. Options are OTM if u.12S
C
u.S7Sor-u.S7S
P
-u.12S, and ATM ifu.S7S <
C
< u.626
or-u.62S <
P
< -u.S7S. IV and delta are computed using Black-Scholes model and the volatility used for computing delta is the
average risk neutral variance in one volatility path.
0 2 4 6 8 10 12
-0.2
-0.15
-0.1
-0.05
0
Variance Premium
S
l
o
p
e

o
f

I
V
F
0 5 10
0.2
0.3
0.4
0.5
Variance Premium
I
V

o
f

A
T
M

o
p
t
i
o
n
s




49






Figure2 SP500 I ndex Level, PDS, PDI and Consumer Sentiment
PDS is the positive-exposure demand for stock options, calculated as the monthly sum of the nonmarket maker open buy call and sell put
volumes minus sum of open sell call and buy put volumes across all stock options, and PDI is the net positive-exposure demand for S&P500
index options. The level of SP500 index is indicated by the dashed line.
Oct90 J an94 J an00 J an04 J un08
-4
-2
0
2
4
x 10
6
PDS and SP500
P
D
S
400
800
1200
1600
S
P
5
0
0
Oct90 J an94 J an00 J an04 J un08
-10
-5
0
5
x 10
5
PDI and SP500
400
800
1200
1600
S
P
5
0
0
Oct90 J an94 J an00 J an04 J un08
50
100
Consumer Sentiment (CS)



50







J an1990 J ul1992 J an1995 J ul1997 J an2000 J ul2002 J an2005 J ul2007
0
20
40
60
80
Stock Option Trading
V
o
l
u
m
e

%
J an1990 J ul1992 J an1995 J ul1997 J an2000 J ul2002 J an2005
20
0
J ul2007
40
60
80
Index Option Trading
V
o
l
u
m
e

%
Discount/Small
Full/Large
Other/Medium

Figure 3 Stock and SP500 index option trading of different types of investors or trade sizes.
The monthly percentage trading volume of discount brokerage customers, full service customers, and the other public customers
before 2002, and percentage trading volume of small, large and medium trade from 2002 onwards. Percentage trading volume is
measured as the total volume originated from specific investor or trade group divided by total non-market maker volume. The
percentage trading volume of firm proprietary traders