Option trading and equity price efficiency

Abstract

This paper presents evidence that the reduction in option tick size enhances equity price efficiency. To address the endogeneity issue, I employ an exogenous event, namely the Penny Pilot program. The findings indicate that option trading mitigates equity misvaluation, reduces price delay, accelerates the incorporation of future earnings into equity prices, and eliminates the well-known Post-Earnings Announcement Drift (PEAD). The pilot program significantly increases trading volume and reduces trading costs during the pilot period. Furthermore, the effect of options-to-stock volume on future stock returns is stronger in firms with high short-sale costs. This evidence is consistent with the hypothesis that informed trading boosts trading volume in the options market and integrates information from the options market into equity prices, thereby enhancing equity price efficiency.