Order Flow and Expected Option Returns

Abstract:     
The paper presents three pieces of evidence that the inventory risk faced by market makers has a first-order effect on expected option returns. First, option expiration dates trigger exogenous variation in order imbalance as investors roll over their positions to non-expiring options. The selling pressure around expiration dates pushes option prices down by 5.7% while the underlying stock price and volatility remain unchanged. Second, the analysis is extended beyond the expiration period by an instrumental variable approach that exploits the persistence in order imbalances. If the inventory-related order imbalance increases by one standard deviation, the next-day option return is 1% higher which is larger than for any of control variables. Finally, I develop a market microstructure method to decompose the price impact of trades into inventory and information components. Option trades have substantial price impact, and the inventory component is larger than the information component for any trade size.

Number of Pages in PDF File: 61

Keywords: Option returns, order imbalance, inventory, equity options

JEL Classification: G14, G10, G12, G13

working papers series