Firm Growth Potential and Option Returns

Abstract

This paper shows that firm growth potential – representing a firm's yet-unexercised growth opportunities – is associated with option overpricing and low future delta-hedged option returns. We provide an explanation of this phenomenon based on the idea that retail investors exert buying pressure and tend to overpay for the call options of growth-oriented firms because they overestimate the potential profits arising from the return skewness of the underlying stocks. We further show that the effect is stronger among stocks that are more likely to exhibit high skewness, are more prone to limits-to-arbitrage and are more exposed to informational frictions.