Pearson, Poteshman & White — Does Option Trading Have a Pervasive Impact on Underlying Stock Prices? (2006 working paper; RFS 34(4), 2021)
T1 — the published version is Ni, Pearson, Poteshman & White, Review of Financial Studies 34(4), 2021, pp. 1952–1986 (review-of-financial-studies). What was read here is the earlier working-paper draft dated 31 July 2006, by neil-pearson, allen-poteshman and Joshua White (all University of Illinois at Urbana-Champaign), which carries the line "Preliminary and Incomplete" on its title page. Sophie Xiaoyan Ni joins the author list in the published version. Every number quoted below is the draft's; the published paper restates the headline share but its figures were not read, so do not cite these as the RFS numbers.
This is the measured-hedging half of the Greeks question (options-greeks), and it is the source this spoke's coverage edge asked for: not a list of the quantities, but a test of what hedging them does to a stock.
The mechanism being tested
A delta hedge is not static. option-pricing gets delta from black-scholes as a hedge ratio; gamma is how fast that ratio moves as the stock moves. Someone short options carries negative gamma, so keeping the hedge means buying the stock after it rises and selling after it falls — trading with the move. Someone long options carries positive gamma and does the opposite, trading against it. Theory therefore predicts that when the net gamma of investors who actually hedge is negative, their rebalancing raises the volatility of the underlying, and when it is positive it damps it. Before this paper, that prediction had not been tested; the only accepted evidence that options moved stocks at all was price clustering at strikes on expiration days.
What they could measure
The same chicago-board-options-exchange data behind information-in-option-volume, read for positions rather than direction: daily open interest split by OCC origin code into public customers and firm proprietary traders, purchased and written, 1990–2001. Because open interest nets to zero across all investors, knowing what the non-market-makers hold tells you what the market makers hold — and market makers are the group most likely to delta-hedge. Gammas are computed with Black-Scholes, with a robustness check against OptionMetrics (optionmetrics) Ivy DB gammas for 1996–2001; stock data from CRSP.
The result
A highly significant negative relationship between the net gamma of likely hedgers and the absolute return of the underlying stock — the sign theory predicts. It survives controls for volatility persistence, for the possibility that the positions are themselves bets on volatility, and it holds in large and small stocks, in both halves of the sample, with firm proprietary traders counted as hedgers, and with option-expiration weeks excluded. That last exclusion is what makes the claim "pervasive": the effect is not the expiration-day pinning already known.
Size: the average daily absolute return in the sample is 310 basis points, and a one-standard- deviation shock to net gamma moves it by 37bp — so on the order of 12% of the daily absolute return of an optioned stock is attributable to option participants rebalancing hedges. A sanity check on the plausibility of that: a one-standard-deviation shock to estimated hedge-rebalancing volume moves total stock volume by about 14% of its average.
Why it belongs beside the flow signal
information-in-option-volume says option order flow predicts the stock because someone knows something. This paper says option positions push the stock whether or not anyone knows anything — a mechanical channel with no information in it. Both are readings of the same order flow, and they have opposite implications for the same observed trade, which is the crux of combining Greeks with unusual-options-activity and is worked through on dealer-gamma-exposure.
It also settles an older argument the introduction reviews: the literature could never find whether listing options raised or lowered volatility, and the answer here is that it does both, with the sign set by who is holding what.
Related
dealer-gamma-exposure · options-greeks · unusual-options-activity · information-in-option-volume · gamma-fragility · option-pricing · black-scholes · neil-pearson · allen-poteshman · synthesis