How electronic trading affects bid-ask spreads and arbitrage efficiency between index futures and options

Abstract

This paper examines the impact of switching to electronic trading on the relative pricing efficiency of Hang Sang Index futures and options contracts traded on the Hong Kong exchange. The study is motivated by the recent shift in 2000 from the pit to an electronic trading platform. Electronic trading leads to lower bid-ask spreads and less price clustering

Threshold non-linear dynamics between Hang Seng stock index and futures returns

“…While the dynamics between HSI index and futures returns have been documented (Tang, Mak, and Choi 1992;Chiang and Fong 2001;Jiang, Fung, and Cheng 2001;Draper and Fung 2003;Chan, Chan, and Cheng 2004;Chiang and Wang 2008), including the potential arbitrage associated with mispricing (Cheng, Fung, and Tse 2005;Zhang and Lai 2006;Wang 2008), the investigation of the non-linear dynamics between the Hang Seng stock index and futures returns remains relatively unexplored. Consequently, this investigation adds to a developing literature that applies more complex modelling techniques (Eling and Toplek, 2009), such as Fractionally Integrated Error Correction models (Rajaguru and Pattnayak 2007), Exponential Generalised Autoregressive Heteroskedastic models (Butler and Okada 2008), Markov switching models (Okimoto 2008), or wavelet analysis (In and Kim 2006) Martens, Kofman and Vorst (1998) utilises a threshold error-correction model to investigate the complex dynamics between intraday Standard & Poors 500 futures and index returns, our main objective lies in the application of a Threshold AutoRegressive (TAR) model to the Hong Kong stock and futures markets.…”

Price Clustering in Individual Equity Options: Moneyness, Maturity, and Price Level

“…Moneyness is reflected in the PL of options contracts. In‐the‐money options contracts trade at higher PLs (all else being equal); hence, one might expect greater price clustering (as implied by Cheng at al., ). ap Gwilym et al () report that keeping maturity constant, less clustering is associated with in‐the‐money index options.…”

“…Theory suggests that price clustering in financial markets could be a function of price uncertainties (Aitken, Brown, Buckland, Izan, & Walter, ; Ball, Torous, & Tschoegl, ), could arise from a need to minimize trade negotiation costs (Harris, ), or could reflect investors’ attraction to particular numbers (Goodhart & Curcio, ) and, given the existence of market makers, the tendency of the latter to maintain wider spreads (Christie & Schultz, ). In derivatives markets, empirical studies are mainly focused on the futures markets (e.g., ap Gwilym, Clare, & Thomas, ,; Schwartz, Van Ness, & Van Ness, ) and the sparse evidence on options contracts (ap Gwilym et al, ; Capelle‐Blancard & Chaudhury, ; Cheng, Fung, & Tse, ) is restricted to stock index contracts. Finally, Ni, Pearson, and Poteshman () show that option trading induces stock price clustering.…”

“…The findings of ap Gwilym et al () and Capelle‐Blancard and Chaudhury () offer more support for the attraction hypothesis than for other theories on price clustering. Cheng et al () report that quote and bid–ask spread clustering on the Hang Seng index futures and options decreased following a switch to electronic trading. The implementation of a relatively low tick size increased execution efficiency and transparency, allowing traders to use the full range of available prices.…”

The impact of execution delay on the profitability of put‐call‐futures trading strategies—Evidence from Taiwan

“…The last settlement price for both futures and options is the simple average of the first 15-minute index value on the business day next to the expiration day. 10 Fung and Mok (2001) and Cheng, Fung, and Tse (2005) indicate a similar difficulty on the Hong Kong market. The option market makers may call out "not held" and revise quotes when there is misalignment.…”