Tick Size, Microstructure Noise, Informed Trading and Volatility Inversion Effects on Price Discovery in Option Markets: Theory and Empirical Evidence

57 Pages Posted: 18 Mar 2012

See all articles by Michal Czerwonko

Michal Czerwonko

McGill University

Nabil Khoury

University of Quebec at Montreal (UQAM) - Faculty of Management (ESG)

Stylianos Perrakis

Concordia University, Quebec - John Molson School of Business

Marko Savor

University of Quebec in Montreal

Date Written: March 16, 2012

Abstract

We document both theoretically and empirically a major dependence in both the Information Shares (IS) and Component Shares (CS) approaches to the estimation of the price discovery metrics on the errors arising out of the inversion method of the option value to find the implied stock price, as well as on the statistical technique used to estimate these metrics. We then introduce accurate inversion methods that result in a major increase in the information shares of option markets for both IS and CS metrics compared to the dominant Lagged Implied Volatility inversion method. We apply these insights by examining the impact of the tick size reduction introduced by the CBOE in 2007 in its second pilot program on the simultaneous price discovery process in the markets for options and their underlying securities. In all cases we document a major impact of the tick size reduction in the option market that increases the option market information shares for all metrics, all statistical techniques used for their estimation, and all inversion methods. In addition, we document systematic differences in option market information shares between equities and exchange traded funds both before and after the tick size change, and we present strong event-type empirical evidence of informed trading in the equity option market after the tick size change, with extreme values of the IS and CS metrics in that market producing similar abnormal underlying asset returns.

Keywords: contingent claims, market microstructure, volatility inversion, price discovery, tick size

JEL Classification: G14, G15

Suggested Citation

Czerwonko, Michal and Khoury, Nabil and Perrakis, Stylianos and Savor, Marko, Tick Size, Microstructure Noise, Informed Trading and Volatility Inversion Effects on Price Discovery in Option Markets: Theory and Empirical Evidence (March 16, 2012). Available at SSRN: https://ssrn.com/abstract=2025035 or http://dx.doi.org/10.2139/ssrn.2025035

Michal Czerwonko

McGill University ( email )

1001 Sherbrooke St. W
Montreal, Quebec H3A 1G5
Canada

Nabil Khoury

University of Quebec at Montreal (UQAM) - Faculty of Management (ESG) ( email )

Case postale 8888
Succursale Centre-ville
Montreal, Quebec H3C 3P8
Canada
514-987-3000 x6717 (Phone)

Stylianos Perrakis

Concordia University, Quebec - John Molson School of Business ( email )

1455 de Maisonneuve Blvd. W.
Montreal, Quebec H3G 1M8
Canada

Marko Savor (Contact Author)

University of Quebec in Montreal ( email )

Case postale 8888
Succursale Centre-ville
Montreal, Quebec H3C 3P8
Canada
514-987-3000 ext.: 8553 (Phone)

HOME PAGE: http://www.uqam.ca

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