What's Gone Wrong with Option Liquidity: Evidence from the Knight Capital's Trading Glitch

56 Pages Posted: 2 Mar 2020 Last revised: 14 Jul 2020

See all articles by Nikunj Kapadia

Nikunj Kapadia

University of Massachusetts Amherst - Department of Finance

Matthew Linn

Isenberg School of Management, University of Massachusetts

Date Written: August 15, 2019

Abstract

Since the early 2000s liquidity in option markets has become less resilient, and our evidence suggests that it is so because of an increased vulnerability to liquidity shocks in the underlying. To demonstrate the causal impact, we consider an incident in which a large broker dealer erroneously executed millions of orders in the stock market. The computer glitch increased uninformed order flow resulting in liquidity-related uncertainty in the equity market. Option spreads of impacted stocks widened by as much as one-third while abnormal stock order flow was ongoing and remained wide until uncertainty about the glitch was resolved. The evidence is consistent with a mechanism whereby option market makers face risk of being picked off with every revised quote in the underlying. Option market participants bear higher adverse selection costs than equity market participants, making the derivative markets fragile.

Keywords: Liquidity, High-Frequency Trading, Options

JEL Classification: G12, G13, G14

Suggested Citation

Kapadia, Nikunj and Linn, Matthew, What's Gone Wrong with Option Liquidity: Evidence from the Knight Capital's Trading Glitch (August 15, 2019). Available at SSRN: https://ssrn.com/abstract=3517429 or http://dx.doi.org/10.2139/ssrn.3517429

Nikunj Kapadia

University of Massachusetts Amherst - Department of Finance ( email )

Amherst, MA 01003
United States
413-545-5643 (Phone)
413-545-5600 (Fax)

HOME PAGE: http://www-unix.oit.umass.edu/~nkapadia/

Matthew Linn (Contact Author)

Isenberg School of Management, University of Massachusetts ( email )

Amherst, MA 01003
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
48
Abstract Views
384
PlumX Metrics