28 Pages Posted: 16 Jan 2011
Date Written: January 13, 2011
Underlying each stock trades hundreds of options at different strike prices and maturities. The order flows from these option transactions reveal important information about the underlying stock price. How to aggregate the trade information of different option contracts underlying the same stock presents an interesting and important question for developing microstructure theories and price discovery mechanisms in the derivatives markets. This paper takes options on QQQQ, the Nasdaq 100 tracking stock, as an example and examines different order flow consolidation mechanisms in terms of their effectiveness in extracting information about the underlying stock price and volatility movements. The analysis leads us to propose an aggregation weighting scheme that depends both on the liquidity of each option contract and the contract's risk exposure, delta for stock price movement information and vega for volatility movement information. Based on this weighting scheme, we identify significantly positive correlations between the aggregate option order flows and the realized returns and volatilities. In particular, the delta buy pressure positively predicts the underlying return and the vega buy pressure positively predicts the change of volatilities.
Suggested Citation: Suggested Citation
Hu, Jianfeng and Holowczak, Richard and Wu, Liuren, Consolidating Information in Option Transactions (January 13, 2011). Available at SSRN: https://ssrn.com/abstract=1740046 or http://dx.doi.org/10.2139/ssrn.1740046