Risks and Hedges of Providing Liquidity in Complex Securities: The Impact of Insider Trading on Options Market Makers

Abstract

This Article analyzes the impact of insider trading on options market makers from the perspective of the characteristics of options as complex securities, the structural features of options markets, and the corresponding unique risks and hedges of these market participants. It is argued that options market makers, as opposed to their counterparts in equity markets, suffer unique substantial losses from insider trading, and evidence to support this proposition is offered. Judicial decisions on losses of options traders from insider trading are reviewed and critiqued in order to develop several elements of a methodology for calculating losses of options market makers. The uniqueness of risks and hedges of options market makers is further illustrated in the context of fraud-on-the-market.

Keywords: Insider Trading, Derivatives, Options, Options Market Makers, Inventory Management, Fraud-on-the-Market

JEL Classification: D82, G28, K22