Overcoming Arbitrage Limits: Option Trading and Momentum Returns

Abhay Abhyankar, Ilias Filippou, and Pedro A. Garcia-Ares

Momentum profits depend mainly on the short leg and therefore on barriers to short sales. Our research indicates that the decline in momentum profitability in the past two decades is driven partly by a contemporaneous growth in stock options trading. Stock options offer an alternative to short selling, augmenting the stock lending market, and thereby contributing to improved pricing efficiency. The resulting reduction in barriers to short sales contributes to lower returns to momentum trading from the short leg. Our results persist after matching stocks with and without options based on different firm-level characteristics.