N°18-02: Option Trading Under Uncertainty

We investigate optimal trading strategies under uncertainty in a nonparametric no-arbitrage framework that is consistent with an arbitrary number of assets. We show that extreme aversion to uncertainty precludes trading, and that preference for uncertainty induces market participation.  
In an empirical exercise using S&P 500 options, we find that magnitudes of optimal portfolio positions are small when uncertainty is high, whereas risk-based models usually predict the opposite. They also strongly co-move with trading volume. Differences in beliefs modelled through differences in agents' ambiguity priors lead to an equilibrium in which agents' ambiguity aversion is persistent over time.