Individual stocks options in aggregate may appear to be similar to index options in that they are driven by the same fundamentals and their prices are affected by risk in similar ways. But they are dissimilar in one important way: they are generally traded by two different groups of people, each of whom have different motivations that affect how they trade and price these options.

Michael Lemmon and Sophie Xiaoyan Ni showed, in a study on the factors driving stock and index options trading and pricing, just how these motivations led to different behaviors by each group.

Following up earlier findings that most trades in S&P 500 index options involved puts, indicating that institutional investors were hedging against market declines, and that hedging trades accounted for only a small fraction of stock option trading, the authors examined data from more than 4,800 U.S. firms from 1990-2010 and compared it with measures of investor sentiment, among other variables.

“Options on individual stocks are actively traded by unsophisticated investors who appear to use options largely to speculate on future price movements,” they reported. “They tend to increase their exposure to stocks through opening options positions, especially for out-of-the-money options, when individual sentiments are high and following high market returns.

“In contrast, trades in index options are more often motivated by the hedging demand of sophisticated investors, including firm proprietary traders. These traders appear to act more like market makers and take the opposite side of these trades.”

The authors measured options trading through positive exposure demand for individual stock options, and positive exposure demand for S&P 500 index options. They confirmed that investors increased stock options when sentiments and lagged market returns were high, but that index options trading was unrelated to these factors. Options pricing showed a very similar pattern.

“The pricing impact was more pronounced in stock options with a higher concentration of speculative trading, higher stock return volatility, and high volatility of volatility,” they said.

These results underscored an important factor in security prices. “The finding that individual stock and index options markets are segmented because of differences in the composition of investor types is consistent with the notion that factors not related to fundamentals affect security prices from a unique angle,” they said.

The authors added that their study did not contradict other findings that index options might also be subject to behavior biases. “Rather, we infer that the prices of index options are less subject to the behavioral biases of noise traders.”

Overall, this study provides new evidence that sentiments and market returns affect the demand and pricing of securities traded actively by individual investors, but that they have little effect on the prices of those securities in which demand is driven by the hedging motives of more rational investors.