The Impact of Options Trading on the Market Quality of the Underlying Security: An Empirical Analysis

Abstract

We find that option listings are associated with a decrease in the variance of the pricing error, a decrease in the adverse selection component of the spread, and an increase in the relative weight placed by the specialist on public information in revising prices for the underlying stocks. We also find that there is a decrease in the spread and increases in quoted depth, trading volume, trading frequency, and transaction size after option listings. Overall, our results suggest that option listings improve the market quality of the underlying stocks.THIS STUDY EMPIRICALLY examines the impact of stock option listings on several aspects of the market quality of the underlying stocks. The motivation for this examination is to provide new and comprehensive evidence on whether stock options, in particular, and derivative securities, in general, have a beneficial or a harmful effect on the market for the underlying securities.We show that the previously documented decrease in the bid-ask spread following option listings is accompanied by an increase in the number of contracts the specialist is willing to trade at the quoted prices (quoted depth). Furthermore, the spread decreases and the depth increases even after controlling for changes in trading volume, volatility, and price. Lower spread and higher depth together provide unambiguous evidence of higher liquidity, and suggest that larger trades can be executed at lower transaction costs after option listings. Consistent with this, we find that the increase in trading volume after option listing is a combined effect of higher trading frequency and larger average transaction size.

The relevance of information and trading costs in explaining momentum profits: Evidence from optioned and non-optioned stocks

“…For example, while Damodaran and Lim (1991) and Kumar et al (1998) show that option trading decreases the bid-ask spread, Stein (1987) finds contrary effects of option trading on bid-ask spreads of the underlying stocks. However, Fedenia and Grammatikos (1992) suggest that highly liquid stocks tend to have spread increases after option introduction, while the opposite effect holds true for illiquid stocks.…”

“…First, options are normally only issued on relatively large liquid stocks (see, for example, Mayhew and Mihov, 2004). Second, evidence suggests that option trading increases liquidity for the underlying stocks (see, Kumar et al (1998) As liquidity is found to improve following option listing, it is expected that optioned stocks should generate lower momentum profits than non-optioned stocks.…”

The Effect of Put Option Issuing on Risk Adjusted Return

“…They also found that there was a decrease in the transaction size after option listings. Overall, their results suggested that option listings improved the market quality of the underlying stocks (Kumar, Sarin, & Shastri, 1998). …”

The Impact of Warrant Introduction: The Australian Experience

“…Kumar et al (1998) find that introducing options increases the market quality of the underlying asset, as measured by 26 While recently regulators have generally not held an official position regarding introducing new derivatives, evidence of some concern is obvious from the moratorium restricting new option listings that the SEC placed on options exchanges between 1979 and 1981. This is discussed in Conrad (1989).…”