Option trading and the cross‐listed stock returns: Evidence from Chinese A–H shares

Abstract

We empirically investigate the effects of option trading on the cross-listed stock returns. Using dual-listed stocks in mainland China (A) and Hong Kong (H) stock exchanges, we show that option order imbalance (OI) positively and significantly predicts daily stock returns for both markets, controlling for risk factors and firm characteristics. Informed trading rather than price pressure better explain the predictability. High OI stocks have higher trading volume and present lottery-like properties. Three important events significantly affect the predictive power of OI, consistent with the improved market quality and the episode of speculative trading. Robustness checks support the main findings.

Price monotonicity violations during stock market crashes: Evidence from the SSE 50 ETF options market

“…As previously discussed, there are more professional and informed traders in the Chinese options market than in the spot market, which speeds up information transmission and incorporation in the options market. Therefore, despite its short history, the Chinese options market plays an influential role in the price discovery process (Ahn et al, 2019; Luo et al, 2020). When the information conveyed by option prices flows from the options market to the spot market, it usually takes longer for the spot market (where noise traders dominate) to absorb the information and then act, which causes the Type III violation occurrence rates to rise and exceed those of Type II.…”

“…Hence, one can expect information incorporation efficiency in the options market to be much higher than that in the spot market and Type III violations to be more frequent subsequently. Meanwhile, most professional options traders in China are informed and accessible to private information (Ahn et al, 2019;Luo et al, 2020Luo et al, , 2022, which contributes to immediate price changes in response to shocks in the options market. 2 Moreover, speculative trading activities account for a substantial proportion of Chinese options trading.…”

“…We attribute this unique feature to the options market's significant role in the price discovery process in China. The typical investor components and strict market entry requirements make the Chinese options market more efficient in transmitting and sharing information than the spot market (Ahn et al, 2019; Luo et al, 2020). When new information is instantly incorporated and reflected into prices in the options market (where professional investors and informed traders dominate), it usually takes longer for the spot market (where noise traders dominate) to absorb the same information and then react to it.…”

Why are the prices of European‐style derivatives greater than the prices of American‐style derivatives?

“…We construct our proxy for liquidity providers' behavior using the warrant/option order imbalance (OI) inspired by Christoffersen et al (2018), which reflects the inventory risk of liquidity providers. We use a method to calculate OI following Bernile et al (2016) and Luo et al (2020). 4 Thus, the variables measuring liquidity providers' behavior, Lp i t…”

“…We construct our proxy for liquidity providers' behavior using the warrant/option order imbalance (OI) inspired by Christoffersen et al (2018), which reflects the inventory risk of liquidity providers. We use a method to calculate OI following Bernile et al (2016) and Luo et al (2020). Thus, the variables measuring liquidity providers' behavior, $${{Lp}}_{i,t}^{{\rm{w}}}$$ and $${{Lp}}_{i,t}^{{\rm{o}}}$$, are equally given by $$${{Lp}}_{i,t}=|{{OI}}_{i,t}|=\frac{{\rm{|}}\sum _{n=1}^{N}{{Vol}{\rm{\$}}}_{i,n}^{\mathrm{Buy}}-\sum _{n=1}^{N}{{Vol}{\rm{\$}}}_{i,n}^{\mathrm{Sell}}{\rm{|}}}{{\sum }_{n=1}^{N}{{Vol}{\rm{\$}}}_{i,n}},$$$where $${{Vol}{\rm{\$}}}_{i,n}^{\mathrm{Buy}}$$ and $${{Vol}{\rm{\$}}}_{i,n}^{\mathrm{Sell}}$$ refer to the trading volume of warrants and options in Hong Kong dollars, respectively.…”