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

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...

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Bibliographic Details
Published inReview of financial economics Vol. 14; no. 1; pp. 1 - 23
Main Authors Chen, Carl R., Lung, Peter P., Tay, Nicholas S.P.
Format Journal Article
LanguageEnglish
Published New Orleans Elsevier Inc 2005
Elsevier
Elsevier Science Ltd
SeriesReview of Financial Economics
Subjects
Economic theory
G12
G13
G14
Hypotheses
Information flow
Informed trading
Options markets
Options trading
Securities trading
Studies
G13
G12
G14
Informed trading
Information flow
Options markets
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Summary: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.
ISSN:1058-3300
1873-5924
DOI:10.1016/j.rfe.2004.03.001