Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?

Abstract

This paper examines the relation between net buying pressure and the shape of the implied volatility function (IVF) for index and individual stock options. We find that changes in implied volatility are directly related to net buying pressure from public order f low. We also find that changes in implied volatility of S&P 500 options are most strongly affected by buying pressure for index puts, while changes in implied volatility of stock options are dominated by call option demand. Simulated delta-neutral optionwriting trading strategies generate abnormal returns that match the deviations of the IVFs above realized historical return volatilities.If people are willing to pay foolish prices for insurance, why shouldn't we sell it to them? (Lowenstein (2000)).ONE OF THE MOST INTRIGUING ANOMALIES REPORTED in the derivatives literature is the "implied volatility smile." The name arose from the fact that, prior to the October 1987 market crash, the relation between the Black and Scholes (1973) implied volatility of S&P 500 index options and exercise price gave the appearance of a smile. Since October 1987, however, the index implied volatility function (hereafter, IVF), as we refer to it, decreases monotonically across exercise prices. Under the assumptions of the Black-Scholes model, the IVF should be f lat and constant through time.Most attempts to explain the shape of the IVF focus on relaxing the BlackScholes assumption of constant volatility by allowing the local volatility rate of underlying security returns to evolve either deterministically or stochastically through time. Emanuel and MacBeth (1982) examine the power of the deterministic Cox and Ross (1976) constant elasticity of variance (CEV) model to explain the cross-sectional distribution of stock option prices. With its additional degree of freedom, the CEV model (necessarily) fits the observed structure of option prices better than the Black-Scholes constant volatility model. Out of sample, however, Emanuel and MacBeth conclude that the CEV model does * Owen Graduate School of Management, Vanderbilt University and Fuqua School of Business, Duke University. We gratefully acknowledge the comments/assistance of Cliff Ball, Alon Brav, Mike Lemmon, Joseph Levin, Joshua Rosenberg, Eileen Smith, Tom Smith and seminar participants at Vanderbilt University, Nashville, TN, and the 2003 American Finance Association meetings, Washington, D.C. We are especially grateful to an anonymous referee for providing many useful and insightful comments and suggestions. 712The Journal of Finance no better than the Black-Scholes model. Similarly, the implied binomial tree framework of Dupire (1994), Derman andKani (1994), andRubinstein (1994) offers a deterministic local volatility structure so f lexible that, in sample, it can describe the cross-section of options prices exactly at any point in time. 1 Empirical tests by Dumas, Fleming, and Whaley (1998), however, show that a model based on a simple deterministic volatility structure has parameters that are highly ...

A High‐Frequency Investigation of the Interaction between Volatility and DAX Returns

“…This observation is compatible with our findings of Section 3.1. Bollen and Whaley (2004) find that implied volatility returns of S&P500 options are directly related to net buying pressure for index puts. The results suggest that this buying pressure, which is typically decreasing with moneyness, drives the downward sloping shape of the implied volatility function.…”

Cross Economic Determinants of Implied Volatility Smile Dynamics: Three Major European Currency Options

“…Recent empirical option pricing literature (see, for example, Bollen and Whaley, 2004;Chan et al, 2004;Garleanu et al, 2009) reaches a consensus that net hedging pressure is a major factor in explaining the shape and dynamic of the implied volatility curve. The idea is that, given limits to arbitrage, the option supply curve should be upward sloping instead of a horizontal line, so net demand for options positively affects option prices.…”

Asymmetric Volatility and Trading Activity in Index Futures Options

“…We examine both the hypotheses in different option market liquidity environments. Bollen and Whaley (2004) first introduce the net buying pressure hypothesis in index option markets. Because institutional investors heavily purchase out-of-themoney (low exercise price) index put options, market makers cannot unload positions and are forced to accumulate out-of-the-money put option inventory.…”

“…Following Bollen and Whaley (2004), if the implied volatilities of low exercise price options are influenced by noninformative trading (i.e., net buying pressure), they will be less sensitive to index futures returns than the implied volatilities of high exercise price options. Thus, the asymmetric response of implied volatilities to index futures returns should vary across option moneynesses.…”

“…We examine both hypotheses under different liquidity conditions. Bollen and Whaley (2004) suggest that institutional investors use low exercise price (out-of-the-money) index put options in considerable amounts to hedge their portfolios. Consequently, premiums of index put options with low exercise prices are driven up as buying pressure increases.…”