Overreactions in the Options Market



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    • Harvard Business School. I am grateful to Mark Zurack of Goldman Sachs and Co. for providing me with the data on index options and to Bill Fairburn for stellar research assistance. Thanks also to Ken Froot for several helpful discussions and to Fischer Black, René Stulz, and an anonymous referee for their suggestions.


This paper examines the “term structure” of options' implied volatilities, using data on S&P 100 index options. Because implied volatility is strongly mean reverting, the implied volatility on a longer maturity option should move by less than one percent in response to a one percent move in the implied volatility of a shorter maturity option. Empirically, this elasticity turns out to be larger than suggested by rational expectations theory—long-maturity options tend to “overreact” to changes in the implied volatility of short-maturity options.