The Information Content of Option Demand

Abstract:     
This paper investigates the relation of stock returns and option demand imbalances due to an excessive option demand of investors with information on the underlying. Furthermore, we address the impact of informed option demand on price pressure in option markets. We derive a measure that captures the excess option demand of informed traders and empirically verify its predictive power for stock returns. We find economically significant returns for option market strategies that trade on the informed demand in options (e.g., 25% or 39% for out-of-the-money long calls or puts with 1-month time to maturity). Additionally, informed option demand is associated with an increase in option bid-ask spreads and put-call parity violations, implying that informed trading reduces liquidity in the option market and increases deviations from the arbitrage equilibrium.

Number of Pages in PDF File: 33

Keywords: Asymmetric Information, Option Market Demand, Market Sidedness, Open Interest, Liquidity, Market Microstructure

JEL Classification: D82, G10, G12, G14

working papers series