Informed Option Trading Strategies

35 Pages Posted: 18 Feb 2003

See all articles by Cyriel de Jong

Cyriel de Jong

Erasmus University Rotterdam (EUR) - Department of Financial Management; Erasmus Research Institute of Management (ERIM)

Date Written: 18 2001, 10

Abstract

We use a sequential trade model to clarify two mechanisms following the introduction of an option that may lead to increased efficiency in the underlying. On the one hand, market makers learn from trades in the option market and set more accurate prices. On the other hand, the proportion of informed traders in the stock market may be altered depending on the informed traders' strategies. If insiders trade a larger fraction than uninformed traders in the stock, for example because the immediate profits in the stock are larger, spreads in the stock widen, and price errors may increase. This reduces the efficiency increase from the 'learning' effect, possibly to the extent that overall efficiency deteriorates. We use simulations to analyze the resulting impact in a dynamic setting. For realistic parameter values we find that option trading leads to lower price errors in the underlying. The more popular options are, the more quickly information is incorporated in the underlying prices. However, uninformed traders do not necessarily benefit from this speedier convergence. Their stock performance crucially depends on the insider's trading strategy and the fraction of informed trading.

Keywords: Options, market efficiency, price discovery, asymmetric information, leverage

JEL Classification: M, G3, G13

Suggested Citation

De Jong, Cyriel, Informed Option Trading Strategies (18 2001, 10). ERIM Report Series Reference No. ERS-2001-55-F&A. Available at SSRN: https://ssrn.com/abstract=370913

Cyriel De Jong (Contact Author)

Erasmus University Rotterdam (EUR) - Department of Financial Management ( email )

P.O. Box 1738
Room T09-53
3000 DR Rotterdam
Netherlands
+31 10 408 2300 (Phone)
+31 10 408 9017 (Fax)

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

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