Does option trading affect idiosyncratic momentum?

Abstract

Portfolios in idiosyncratic momentum are formed on past residuals of the Fama-French three factor model rather than past total returns. This study examines whether the idiosyncratic momentum strategy can sustain excess returns following the emergence of traded options. We compare idiosyncratic momentum returns with traditional momentum returns over different holding periods and over difference in traded options. Our results show that idiosyncratic momentum returns for stocks with options are positive for three, six, and twelve months following the formation date, while traditional momentum returns for those with options are insignificant or even turn to negative. We also find strong evidence that the enhanced information efficiency led by short selling has impacts more on traditional momentum than on idiosyncratic momentum. While traditional momentum disappears on stocks with traded options, idiosyncratic momentum survives and is still anomalous to the efficient market hypothesis.

JEL Classification:

• G40
• G14

Keywords:

• traditional momentum
• idiosyncratic momentum
• stock option trading
• short sale constraints

PUBLIC INTEREST STATEMENT

The current article investigates idiosyncratic momentum strategy (IMS) relative to traditional momentum strategy (TMS) in the existence of traded stock options.

The momentum strategy implies that out-performing stocks maintain their good performance in the future, while under-performing stocks keep losing their stock price performance. Both strategies are implemented based on the past stock returns. While TMS are formed based on past total returns, IMS are constructed based on past residuals from the Fama-French 3-factor model, which is a well-known asset pricing model in investments.

While constraints on short-selling stock are known to contribute to TMS, traded stock options relax the constraints and increase stock price informativeness. The study found that IMS out-performs TMS, which loses profitability over time and over traded options. IMS generates excess returns even with traded stock options and still is considered anomaly on the asset pricing model.

Acknowledgements

We are grateful for numerous comments from Zhongzhi He and Jin Lei.

Additional information

Funding

The authors received no direct funding for this research.

Notes on contributors

Unyong Pyo

Songchan Guo: My primary research is on behavioral finance. Although financial markets are generally considered efficient, it can show weakness in its efficiency as shown in this article. I believe that the momentum strategy is still open to productive research in behavioral finance.

Unyong Pyo: My research area covers behavioral finance, asset pricing, executive compensation, and corporate finance. Publishing articles in other areas, I return to behavioral finance for momentum strategy as examined in the paper. As finance research uncovers the profitability of momentum strategy, excess turns disappear over time. However, idiosyncratic momentum still survives and offers an interesting research question in behavioral finance.