Behavioral Heterogeneity in the Option Market - Preliminary Draft - March 2008

This paper develops and tests a heterogeneous agents model for the option market. Our agents have differing beliefs about the level of volatility of the underlying stock index and trade accordingly. We consider two types of agents: fundamentalists, who are assumed to expect the conditional volatility to return to the unconditional volatility, and chartists who respond solely to noise from the level process. Agents are able to switch between groups according to a multinomial logit switching mechanism. The model simplifies to a GARCH-type specification with time-varying parameters, which depend on the distribution of agents across types. Estimation results for index options on the German DAX30 reveal that different types of traders are also actively involved in trading volatility. We find evidence that the observed patterns in option prices are the result of heterogeneity in expectations about future volatility.