Option strike effects on stock returns and volatilities

Derivative markets have become so large that they sometimes overshadow the market for underlying securities, causing the so-called ‘tail wags the dog’ effect. In this thesis I present a new perspective on stock price behavior around option strike prices. The standard CAPM factor model for stock returns is extended with additional terms for detecting effects of strike price proximity. To disentangle a strike price effect from round-number effects, the study also uses variables taking option open interest and option gammas into account. The main factor model is extended with ARCH volatility effects, considered in a panel set-up, and estimated using maximum likelihood. I find that strike nearness in combination with a large option open interest affects the returns and market following behavior of the underlying negatively when taking the average daily trading volume in the underlying into account. The negative effect on the market following behavior is confirmed when taking additionally also the net gamma of the option open interest into account. Furthermore the size of the unexpected returns declines consistently if the underlying nears a strike. These results cannot be explained by the human bias for round numbers and are in accordance with existing theory on option pinning effects.