Order Flow and Expected Option Returns
57 Pages Posted: 23 Nov 2011 Last revised: 5 Nov 2015
Date Written: January 20, 2015
I show that the inventory risk faced by market-makers has a first-order effect on option prices. I introduce a simple approach that decomposes the price impact of trades into inventory risk and asymmetric information components. While both components are large for option trades, the inventory risk component is larger. Using the full panel of daily option returns, I find that option order imbalances attributable to inventory risk have five times larger impact on option prices than previously thought. Finally, I find that past order imbalances have greater predictive power than any other commonly used predictor of option returns.
Keywords: Option returns, order imbalance, inventory, equity options
JEL Classification: G14, G10, G12, G13
Suggested Citation: Suggested Citation