Information flow between the stock and option markets: Where do informed traders trade?

Abstract

This paper investigates the flow of information between the equity and options markets. We argue that informed traders, in deciding where to place their trades, are not entirely indifferent to option moneyness, degree of information asymmetry, and option liquidity. Unlike some previous studies that find information to flow unilaterally from equity to options markets, we control for the above factors and discover feedback relations between trades in out‐of‐the‐money (OTM) options and the underlying equities. The finding is consistent with the pooling equilibrium hypothesis, which asserts that informed traders trade in both the equity and options markets. Some informed traders are probably attracted to the out‐of‐the money options because of their higher liquidity, lower premiums, and higher delta‐to‐premium ratios, hence, lending support to the liquidity and leverage hypothesis.

Sovereign rating actions and the implied volatility of stock index options

“…Chakravarty et al, 2004;Chen et al, 2005;Jin et al, 2012). Derivative markets also play a leading role in the price discovery process (e.g.…”

“…Firstly, it is reasonable to include equity markets in models examining the lead-lag behaviour between the option market and credit rating signals due to the fact that the equity market and the option market both play roles in the price discovery process (e.g. Chen et al, 2005). Given the well-known leverage effect, the stock index return helps control for the fact that credit ratings and the option market do not adjust at the same frequency.…”

“…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.…”

The Impact of Options Trading on the Relationship between Research Quotient and Firm Performance

“…Further, Chakravarty et al (2004) and Kaul et al (2004) suggest that informed traders would trade-off between options leverage and the transaction costs associated with the liquidity of options. Chen, Lung, and Tay (2005) discover feedback relations between trades in OTM options and the underlying equities. Some informed traders are probably attracted to the OTM options for their higher liquidity, lower premiums, and higher delta-to-premium ratios.…”

The Liang-Kleeman Information Flow: Theory and Applications

“…The first is what one would envision in the usual sense, i.e., the transference between two parallel parties (for example, two chaotic circuits [1]), which are linked through some mechanism within a system. This is found in neuroscience (e.g., [2][3][4]), network dynamics (e.g., [5][6][7]), atmosphere-ocean science (e.g., [8][9][10][11]), financial economics (e.g., [12,13]), to name but a few. For instance, neuroscientists focus their studies on the brain and its impact on behavior and cognitive functions, which are associated with flows of information within the nervous system (e.g., [3]).…”