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Abstract

Several recent studies present evidence of investor misreaction in the options market. Although the interpretation of their results is still controversial, the important question of economic significance has not been fully addressed. Here this gap is addressed by formulating regression-based tests to identify misreaction and its duration and constructing trading strategies to exploit the empirical patterns of misreaction. Regular S&P 500 index options and long-dated S&P 500 LEAPS are used to find an underreaction that on average dissipates over the course of 3 trading days and an increasing misreaction that peaks after four consecutive daily variance shocks of the same sign. Option trading strategies based on these findings produce economically significant abnormal returns in the range of 1–3% per day. However, they are not profitable in the presence of transaction costs. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:717–752, 2005