Price discovery in stock and options markets

Abstract

Using new empirical measures of information leadership, we find that the role of options in price discovery is up to five times larger than previously thought. Approximately one-quarter of new information is reflected in options prices before being transmitted to stock prices, with options playing a more important role in price discovery around information events. Using unique data on traders prosecuted for insider trading, we find that they often choose to trade in options, attracted by their leverage, and when they do the options share of price discovery is higher. Our results help interpret conflicting findings in the existing literature.

Option trading after the opening bell and intraday stock return predictability

“…Our study complements the work ofHu (2014) andPatel, Putnins, Michayluk, and Foley (2018) who study intraday option-induced order imbalances and the role of options in stock price discovery, respectively, for more recent sample periods.2 GLP suggest that firm proprietary trades do not contain directional information because these traders may use complex spread and volatility option strategies.…”

“…Murayev, Pearson, and Broussard (2013) show option price quotes do not contain economically significant information about future stock prices in a 2003-2006 sample. Over a 10-year period (2003-2013), Patel et al (2018) document that 30% of stock price discovery stems from option trading and this price discovery is more pronounced prior to news events. The differing results of prior studies could originate from the noise in option prices, as argued by Patel et al (2018), or changes in markets over time, but could also be related to the sample sizes of earlier work, ranging from 14 stocks (Chan et al, 2002) to 60 stocks (Chakravarty et al, 2004).…”

“…They find options trading activity is abnormally high both immediately before news days and on news days, suggesting informed options traders both anticipate news and process information effectively. Patel, Putnins, Michayluk, and Foley (2018) also suggest options' contribution to stock price discovery increases around information events. Numerous studies report abnormal option volume prior to information events (e.g., Amin & Lee, 1997;Augustin, Brenner, & Subrahmanyam, 2015;Cao, Chen, & Griffin, 2005;Lung & Xu, 2014), but few studies except Cremers et al (2019) examine option volume on an information event day itself.…”

Show me the money: Option moneyness concentration and future stock returns

“…3 Another branch of this literature examines stock return predictability of option pricing measures. For instance, An, Ang, Bali, and Cakici (2014), Hovakimian (2009), Diavatopoulos, Doran, andPeterson (2008), Kang, Kim, and Yoon (2010), Xing et al (2010), and Yan (2011), explore the stock return 2 In a more recent sample, Patel, Putnins, Michayluk, and Foley (2018) find 30% of new information is reflected in option prices before being transmitted to stock prices, and this percentage is even larger around information events. 3 Han, Kim, and Byun (2017) predict that option trading could be motivated by information about future stock prices (directional information) and/or information about future stock volatility (volatility information).…”

The evolution of price discovery in us equity and derivatives markets

“…Following Mizrach and Neely () and Patel et al (), the effect on the price discovery process is investigated using relative measures of spreads and average trading values. Thus, the ratio of the spread of the E‐mini to that of the SPY ETF is used.…”