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

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