Why Option Prices Lag Stock Prices: A Trading‐based Explanation

Abstract

While many studies find that option prices lead stock prices, Stephan and WVhaley (1990) find that stocks lead options. We find no evidence that options, even deep out-of-the-money options, lead stocks. After confirming Stephan and Whaley's results, we show their results can be explained as spurious leads induced by infrequent trading of options. We show that the stock lead disappears when the average of the bid and ask prices is used instead of transaction prices. Hence, we find no evidence of arbitrage opportunities associated with the stock lead. IN A PERFECT MARKET, price discrepancies should be instantly arbitraged away.In particular, option prices should neither lead nor lag stock prices. In real markets, only very short leads should occur. Traders with private information who are confident that their information is valid and that they will not be detected generally want highly leveraged positions to exploit their advantage. Thus, we might expect options, with their greater leverage, to lead stocks, if information trading is important. Manaster and Rendleman (1982), Bhattacharya (1987), and Anthony (1988) find evidence that options in fact lead stocks.' However, Stephan and Whaley (1990) find just the opposite. A stock lead of a few minutes could be explained by invoking reporting lags or other considerations. But Stephan and WVhaley report a stock lead of fifteen to twenty minutes. Such a lead, if real, is difficult to understand.In this paper we reexamine the evidence. Most previous researchers have computed implied stock prices by inverting the Black and Scholes or another option-pricing equation. We use instead a nonlinear multivariate regression model, first used in finance by Gibbons (1982). This approach is simpler than the approach used earlier in the literature because it requires less information to be implemented. For instance, this approach can be used without knowing the dividend ex-date. However, the traditional approach and the one used here lead to the same results over comparable samples. In particular, we Stulz, the editor. We are especially indebted to an anonymous referee whose comments significantly improved the paper.1 Finucane (1991) finds a similar lead using S & P 100 Index options. However, the case of index options could be different for a variety of reasons, including the infrequent trading of stocks in the index. 1957 1958 The Journal of Finance are able to replicate the results of Stephan and Whaley (1990) with our approach.We propose an explanation for the puzzling lead of stocks over options. The minimum move or tick for a stock is typically one-eighth. The tick for options with prices greater than three dollars is also an eighth, but entails a much larger percentage move in the option price. Thus, small moves in the stock will usually not be immediately reflected in the option because the change in theoretical value of the option is less than the tick and so the option does not trade. The option will trade after the stock has made more than one move in the same direction. He...

The Efficiency Research on Stock Index Derivatives in a Bear Market—The Evidences from Hangseng Index Derivatives Markets

“…Finucane (1991) [14] describes that the measure of the relative index option prices leads the stock market by at least 15 minutes. Chan，Chung and Johnson (1993) [15] use a nonlinear multivariate regression model to report that stocks lead options by 15 minutes confirming Stephan and Whaley's results. They analyze the cause of the lead-lag relationship based on the relatively larger option tick, and it might be a spurious lead by infrequent trading of options.…”

Price discovery in the U.S. stock and stock options markets: A portfolio approach

“…Early studies, e.g., Manaster and Rendleman Jr. (1982) and Bhattacharya (1987) find that options market leads the underlying asset market in revealing information, but more recent studies, e.g., Stephan and Whaley (1990), Chan, Chung, and Johnson (1993), Easley, O'Hara, and Srinivas (1998), Jarnecic (1999), Chan, Chung, and Fong (2002) and Chakravarty, Gulen, and Mayhew (2004), have essentially reversed the conclusion.…”

An analysis of Australian exchange traded options and warrants

“…Thus, permitting a stock market lead and using intra-day data, Stephan and Whaley (1990) find that the stock market leads the options market by up to fifteen minutes. Chan et al (1993) attribute this to price discreteness, while O'Connor (1999) finds that the stock market leads the options market, but the relationship depends on trading costs. While Easley et al (1998) further document results consistent with a stock market lead, Chakravarty et al (2004) document that 17% of the price discovery can be attributed to the options market and that the level of price discovery is related to volume and spreads in both the options and stock markets as well as stock market volatility.…”

“…Chan (1992) formulates an information hypothesis that new market-wide information will be integrated into the price of the product that captures the entire market most quickly. 4 Chan et al (1993) propose the private information hypothesis, which holds that investors with private information trade in the market that maximizes their profits. Considering various factors including margin requirements, borrowing restrictions, transparency, leverage, liquidity and transaction costs and their influence on profitability, the private information hypothesis synthesizes the above hypotheses.…”

“…In practice, however, lead/lag price change relationships between markets and/or securities result from market frictions impeding the price discovery process. Chan et al (1993) recognizing the existence of price discrepancies indicate that arbitrage trading ensures only short-lived lead/lag relationships.…”