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The Informational Role of Index Option Trading
1Emory University; 2West Virginia University; 3Boston College; 4UCLA
Do order flows in index derivatives capture informed trading? We show that net buying pressure in index put options traded on the International Securities Exchange (ISE) positively and robustly predicts S&P 500 index returns. This result survives after controlling for order flow in index calls as well as in other contingent claims; specifically in index futures and the ETF on the index, as well as order flow in the underlying index. The contrarian nature of return prediction from option order flow (net put buying predicts a higher index return) suggests that market makers who take the other side of the option orders have private information, and set quotes to attract orders from outside customers and brokers. Supporting the notion that market makers lower spreads to attract trading when they have information, we find that the predictive ability of put order flow for index options is higher when puts are more liquid.
On the Relation Between S&P 500 Options and VIX Derivatives
Federal Reserve Board
This paper introduces the variance parity that must hold between S&P 500 (SPX) options and VIX derivatives. Exploiting this parity condition, I find that VIX derivatives contribute more to the price discovery of volatility risk than SPX options, even before the 2008 financial crisis when the former were thinly traded. Additionally, I find that consistent with the theory of limited arbitrage, dislocations between SPX option and VIX derivative prices are associated with measures of funding and market liquidity, even after the peak of the crisis is excluded. Specifically, as liquidity conditions deteriorate, investors appear willing to pay premiums for VIX futures relative to SPX options.
How Do Informed Investors Trade in the Options Market
1McGill University; 2NYU Stern School of Business; 3HEC Montréal
We analyze how informed investors trade in the options market ahead of corporate news, when they receive private information about (i) the timing of the announcement and (ii) its potential impact on stock prices. Our simple framework characterizes the optimal strategy in terms of option type, maturity, and strike price that yields the greatest leverage to informed investors and, hence, the most “bang for the buck.” Accounting for uncertainty in the private information signal, as well as market frictions including minimum prices and bidask spreads, we can rank strategies without the need to model risk aversion or price impact. We demonstrate empirically that (i) heterogeneity in unusual options activity ahead of significant corporate news (SCNs) is consistent with the predictions of our framework and (ii) informed trading measures derived from our framework improve the predictability of significant corporate news events.
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Conference: EFA 2017
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