Essays on the Impact of Investors Speculation and Disagreements on Security Prices and Trading Volume

The essays empirically show the impact of investors speculation and disagreements on the returns and trading volume of securities. The results also shed light on the central issues of price formation and investors’ trading motives in security markets.The first essay investigates whether the trading activities of retail investors affect option prices through volatility speculation. This essay empirically shows that higher retail trading proportions are related to lower delta-hedged option returns. The phenomenon is more pronounced before earnings announcements and among stocks with more time-varying and positively skewed volatility. The results suggest that retail investors speculate and pay a lottery premium on the expected future volatility, resulting in more expensive options in terms of higher implied volatilities. This systematic deviation of option-implied volatility from realized volatility suggests retail investor clientele as a behavioral-based driving force of volatility risk premium.The second essay investigates the motive of option trading. It is shown that option trading is mostly driven by differences of opinion, a finding different from the current literature that attempts to attribute option trading to information asymmetry. First, option trading around earnings announcements is speculative in nature and mostly dominated by small, retail investors. Second, around earnings announcements, option turnovers do not predict stock returns, once prior stock returns are controlled for. Third, regression results reveal that option trading is also significantly explained by differences of opinion at ordinary times. While informed trading is present in stocks, it is not detected in options.The third essay provides strong evidence of reduction in informational efficiency when there are short-sale constraints and disagreements. Post earnings announcement returns are found to be significantly lower for stocks with more dispersed opinions and stocks that are exogenously short-sale prohibited by the Hong Kong Stock Exchange, supporting Miller’s (1977) overvaluation hypothesis. The results also suggest short-sale constraint as an explanation to negative post earnings announcement drift.