The Index Effect: Evidence from the Option Market

We document a significantly positive response of delta-hedged option positions on companies entering or leaving the S&P 500 index. Our findings (i) hold for both call and put options, (ii) are robust to placebo- and risk-adjustments, and (iii) are stronger for companies that are likely subject to more demand pressure from stock index investors. The inclusion effect is permanent, while the exclusion effect is transitory. We explore various mechanisms to explain these results, including leading theories of benchmarking, investor recognition, noise trading, and dispersion trading. We find that these explanations cannot individually account for all our novel results.