Sentiment Trades and Option Prices

This paper examines whether trading based on market sentiment can explain mispricing in S&P 500 options. We test the heterogeneous agent s option pricing model developed in Frijns et al. (2010), where our agents have different beliefs about the future level of market volatility and trade accordingly. Our agents trade on long-term mean reversion in volatility as well as on exogenous shocks from the underlying market, but we also consider irrational traders, sentimentalists, that incorporate market sentiment into their beliefs. Our option valuation framework is similar to a stochastic volatility model and is implemented using a filtered historical simulation approach. We find that sentimentalists play an important role in option markets. Their sentiment is an important determinant of index option prices and partly explains the term structure of the index option smile, because it primarily affects short-term options.