Single Stock Call Options as Lottery Tickets: Overpricing and Investor Sentiment

The authors investigate whether the overpricing of out-of-the money single stock calls can be explained by Tversky and Kahneman's [1992] cumulative prospect theory (CPT). They hypothesize that these options are expensive because investors overweight small probability events and overpay for positively skewed securities (i.e., lottery tickets). The authors find that overweighting of small probabilities embedded in the CPT explains the richness of out-of-the money single stock calls better than other utility functions. Nevertheless, overweighting of small probabilities events is less pronounced than suggested by the CPT, is strongly time varying, and most frequent in options of short maturity. The authors find that fluctuations in overweighting of small probabilities are largely explained by the sentiment factor.