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

51 Pages Posted: 11 Mar 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

University of International Business and Economics (UIBE)

Multiple version iconThere are 2 versions of this paper

Date Written: December 10, 2010

Abstract

In this study we examine the rationale behind informed traders decision to speculate on the volatility of the common stock by trading in the derivative or in the cash markets. 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 very precise volatility signals.

Keywords: options, signal precision, transaction costs, volatility trading

JEL Classification: 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 (December 10, 2010). Available at SSRN: https://ssrn.com/abstract=1568018 or http://dx.doi.org/10.2139/ssrn.1568018

Ramazan Gencay

Simon Fraser University ( email )

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

Rajna Gibson (Contact Author)

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

University of International Business and Economics (UIBE) ( email )

10, Huixin Dongjie
Changyang District
Beijing, Beijing 100029
China

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