Toxic Hedging

50 Pages Posted: 1 Jun 2020

See all articles by Mahendrarajah Nimalendran

Mahendrarajah Nimalendran

University of Florida - Department of Finance, Insurance and Real Estate

Khaladdin Rzayev

London School of Economics, Systemic Risk Centre

Satchit Sagade

Goethe University Frankfurt - Department of Finance; Leibniz Institute for Financial Research SAFE

Date Written: February 1, 2020

Abstract

We investigate the role of high-frequency traders (HFTs) in option market making. We show that, overall, HFTs in the underlying market increase the spread and reduce liquidity in option markets through their liquidity-demanding orders. By contrast, the option spread is not impacted by the additional hedging opportunities stemming from HFTs’ liquidity-providing orders because they impose on the option market maker the risk of trading at stale prices in a cross-market setting.

Keywords: market microstructure, high-frequency trading, option market making, liquidity

JEL Classification: G12, G13, G14

Suggested Citation

Nimalendran, Mahendrarajah and Rzayev, Khaladdin and Sagade, Satchit, Toxic Hedging (February 1, 2020). Available at SSRN: https://ssrn.com/abstract=3600977 or http://dx.doi.org/10.2139/ssrn.3600977

Mahendrarajah Nimalendran

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611
United States
352-392-9526 (Phone)
352-392-0301 (Fax)

Khaladdin Rzayev (Contact Author)

London School of Economics, Systemic Risk Centre ( email )

United Kingdom

Satchit Sagade

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, Hessen 60323
Germany
+49 69 798 30085 (Phone)

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 30085 (Phone)

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