Informed Trading in Stock and Option Markets

Abstract

We investigate the contribution of option markets to price discovery, using a modification of Hasbrouck's (1995) "information share" approach. Based on five years of stock and options data for 60 firms, we estimate the option market's contribution to price discovery to be about 17% on average. Option market price discovery is related to trading volume and spreads in both markets, and stock volatility. Price discovery across option strike prices is related to leverage, trading volume, and spreads. Our results are consistent with theoretical arguments that informed investors trade in both stock and option markets, suggesting an important informational role for options.INVESTORS WHO HAVE ACCESS to private information can choose to trade in the stock market or in the options market. Given the high leverage achievable with options and the built-in downside protection, one might think the options market would be an ideal venue for informed trading. If informed traders do trade in the options market, we would expect to see price discovery in the options market. That is, we would expect at least some new information about the stock price to be ref lected in option prices first.Establishing that price discovery straddles both the stock and options markets is important for several reasons. In a frictionless, dynamically complete market, options would be redundant securities. This paper contributes to the understanding of why options are relevant in actual markets, by providing the first unambiguous evidence that stock option trading contributes to price discovery in the underlying stock market. Further, we document that the level *

The bright side of financial derivatives: Options trading and firm innovation

“…Moreover, options are a mechanism for trading on information about future equity volatility, which allows investors with information about stock price volatility to benefit from options (Ni, Pan, and Poteshman, 2008). These notions are further supported by Chakravarty, Gulen, and Mayhew (2004) and Pan and Poteshman (2006), who find that options order flows contain information about the future direction of the underlying asset. More recently, Hu (2014) shows that an options-induced imbalance significantly predicts future stock returns.…”

“…This, in turn, provides incentives for the manager to forgo short-term profits and to invest in innovation. To the extent that the previous literature, both theoretical and empirical, argues that options increase the amount of private information conveyed by prices (e.g., Cao, 1999;Chakravarty, Gulen, and Mayhew, 2004;Pan and Poteshman, 2006;Roll, Schwartz, and Subrahmanyam, 2009;Hu, 2014), we may expect that this rationale also applies in the context of active options markets.…”

“…Moreover, volatility traders would avoid deep ITM or OTM options, as the vega of such options is close to zero. Specifically, Chakravarty, Gulen, and Mayhew (2004) show that the trading volume by agents speculating on volatility tends to be concentrated in at-the-money (ATM) options. In sum, these arguments suggest that moneyness is related to options trading, although they do not establish an unambiguous direction.…”

“…We argue that for firms that are listed on options markets, greater trading activity is associated with an increased propensity to innovate. The literature suggests that active options markets alter incentives for market participants to gather private information that is especially relevant for long-term investments, and trading on such information makes stock prices more efficient (e.g., Cao, 1999;Chakravarty, Gulen, and Mayhew, 2004;Pan and Poteshman, 2006;Hu, 2014). If stock prices are more efficient, other types of (perhaps less-informed) investors learn more about the fundamental value of the firm, which reduces some of the asymmetric information problems connected to R&D. Because prices play an active role (i.e., managers learn from prices) when investment decisions are made, this should then provide firm management with more incentives to engage in value-enhancing innovative activities.…”

Sovereign rating actions and the implied volatility of stock index options

“…This paper investigates the interaction between sovereign rating news and the equity index option market. This market is typically inhabited by institutional informed traders (see Chakravarty et al, 2004;Chen et al, 2005;Jin et al, 2012). Much literature identifies that the derivative markets play a leading role in the price discovery process (e.g.…”