Effect of Stock Market Momentum on Index Options Prices

Do stock index option prices incorporate stock market price momentum, an expectation of continuation of a recent market trend? In their 2004 journal article entitled “Index Option Prices and Stock Market Momentum”, Kaushik Amin, Joshua Coval and Nejat Seyhun test the dependence of broad equity market index option prices on past market returns. Using price data for S&P 100 index (OEX) options for the period 1983-1995, they conclude that:

• Call (put) options are relatively overpriced immediately following strong stock market advances (declines).
• The effect of market momentum on options pricing appears to be concentrated in out-of-the-money, short-maturity options.
• After strong stock market moves, traders speculating on trend continuation should probably employ futures contracts or underlying stocks
  rather than long options. Conversely, traders speculating on trend reversal should probably employ options.
• Similarly, covered call (put) writing is likely to be most profitable following strong stock market advances (declines).

In summary, stock market momentum tends to affect the pricing of broad equity index options such that long options become less (more) desirable for playing continuation (reversal) of strong trends.

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