Options market makers׳ hedging and informed trading: Theory and evidence

• Published in: Journal of financial markets (Amsterdam, Netherlands) Vol. 23; pp. 26 - 58
• Main Authors: Huh, Sahn-Wook, Lin, Hao, Mello, Antonio S.
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.03.2015
• Subjects: Adverse-selection risk; Bid–ask spreads; Daily conditional probability of informed trading; Hedging; Informed trading; Options market making; Adverse-selection risk; Daily conditional probability of informed trading; G10; Hedging; Bid–ask spreads; G14; Options market making; Informed trading; D82
• ISSN: 1386-4181; 1878-576X
• DOI: 10.1016/j.finmar.2015.01.001

We develop a model to analyze the effects of hedging activities by options market makers (OMMs) facing informed trading. The model suggests that OMMs׳ hedging activities motivated by adverse-selection risk lead to wider spreads in both stock and options markets. The hedging effect on spreads is more pronounced in the options market than in the stock market. The effect is larger when the OMMs hedge with the underlying asset than with other options. In addition, hedging activities by the OMMs significantly alter the trading strategies of informed traders. Our empirical tests provide evidence consistent with the key implication of our model. •We develop a model to analyze the effects of hedging activities by options market makers (OMMs) facing informed trading.•OMMs׳ hedging activities motivated by the adverse-selection risk lead to wider spreads in stock and options markets.•The hedging effect on spreads is more pronounced in the options market.•We estimate the daily conditional probability of informed trading and construct measures of OMMs׳ hedging activities.•Empirical tests provide evidence consistent with the key implication of our model.