THE IMPACT OF OPTION EXPIRATION ON UNDERLYING STOCK PRICES AND THE DETERMINANTS OF THE SIZE OF THE IMPACT.

Abstract

The purpose of this study is to investigate the daily return behavior of underlying common stocks in the period surrounding the option expiration date. A second purpose is to determine the variables that may be causing the differential capital market effect across firms. The hypothesis of a negative return effect in the expiration week followed by a positive effect in the subsequent week is tested first. It is shown that this pattern should be expected due to the enhanced opportunity for and profitability of position unwinding, arbitrage and manipulation activity as the expiration date approached. The study period covers 32 expiration periods from 1978 through 1981 and involves a sample of 138 underlying stocks. The study employs the market model for generating abnormal returns on a daily basis. The results support the hypothesis and in particular show that the most significant negative return behavior occurs on Thursday and Friday of the expiration week. The second phase of the study correlates, via a cross-sectional multiple regression model, the suggested expiration induced events of position unwinding, arbitrage and manipulation activities with the return behavior of the underlying stocks. It is hypothesized that those common stocks which exhibit the greatest negative returns in the expiration week are those stocks and related call options that are most heavily involved in position unwinding, arbitrage and manipulation activities. Trading volume in both the underlying stock and the options is suggested as a surrogate for these three activities. Therefore, volume is negatively related to underlying stock returns. Two additional explanatory variables of the expiration week returns are included in the regression model. A negative relationship is hypothesized if options are dually listed and a positive relationship if puts are traded. The results of the tests generally support these hypothesized functional relationships. The study concludes that, although significant abnormal returns and explanatory variables are found, the magnitudes are probably not large enough to profitably exploit after paying transaction and search costs. As puts trading appears to offset the market inefficiencies caused by call option trading, the concern of regulators that options trading unduly affects stock prices seems unwarranted.