Does option trading affect idiosyncratic momentum?

Abstract

Portfolios in idiosyncratic momentum are formed on past residuals of the Fama-French three factor model rather than past total returns. This study examines whether the idiosyncratic momentum strategy can sustain excess returns following the emergence of traded options. We compare idiosyncratic momentum returns with traditional momentum returns over different holding periods and over difference in traded options. Our results show that idiosyncratic momentum returns for stocks with options are positive for three, six, and twelve months following the formation date, while traditional momentum returns for those with options are insignificant or even turn to negative. We also find strong evidence that the enhanced information efficiency led by short selling has impacts more on traditional momentum than on idiosyncratic momentum. While traditional momentum disappears on stocks with traded options, idiosyncratic momentum survives and is still anomalous to the efficient market hypothesis.