The Role of Signal Precision and Transaction Costs in Stock, Option and Volatility Trading

51 Pages Posted: 31 Mar 2009 Last revised: 18 Jan 2010

See all articles by Ramazan Gencay

Ramazan Gencay

Simon Fraser University

Rajna Gibson

University of Geneva - Geneva Finance Research Institute (GFRI); European Corporate Governance Institute (ECGI)

Yi Xue

Department of Economics, Simon Fraser University

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2009

Abstract

In this study, we examine the rationale that informed traders use in choosing various financial instruments in order to speculate on the volatility of the underlying asset, here a common stock. Using a continuous-time trading model, we demonstrate that the quality of the private information regarding the volatility parameter together with the relative transaction costs observed in the various segments of the cash and derivatives markets will determine informed agents' trading habitats. We further show that in the presence of imprecise volatility signals, only the "most sophisticated" traders (those with highly precise volatility signals) will engage in pure volatility bets. Traders with less precise signals will choose a naked option strategy, while traders at the low spectrum of the precision scale will invest in the underlying stock. Thus, the low volume of pure volatility trades observed by Lakonishok et al. (2007) does not necessarily imply that only fringe traders have chosen to speculate on volatility. Rather, it may suggest that the majority of informed traders do not have precise volatility signals.

Keywords: Informed traders, options, stocks, signal precision, transaction costs, volatility trading

JEL Classification: G11, G14

Suggested Citation

Gencay, Ramazan and Gibson, Rajna and Xue, Yi, The Role of Signal Precision and Transaction Costs in Stock, Option and Volatility Trading (August 1, 2009). Swiss Finance Institute Research Paper No. 09-11, Available at SSRN: https://ssrn.com/abstract=1344230 or http://dx.doi.org/10.2139/ssrn.1344230

Ramazan Gencay (Contact Author)

Simon Fraser University ( email )

Department of Economics
8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

Rajna Gibson

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, Geneva 1211
Switzerland
+41.22.379.89.83 (Phone)

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Yi Xue

Department of Economics, Simon Fraser University ( email )

Burnaby, V5A 1S6
Canada

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