High-Frequency Trading (HFT) in the Stock Market and the Costs of Option Market Making
47 Pages Posted: 18 Feb 2021 Last revised: 19 Apr 2021
Date Written: January 1, 2020
Based on granular NASDAQ HFT data, we find that HFT activity in the stock market increases market-making costs in the options markets via two channels: the hedging channel and the arbitrage channel. HFTs' liquidity-demanding orders increase the hedging costs due to a higher stock bid-ask spread and a higher price impact for larger hedging demand. The arbitrage channel subjects the option market maker to the risk of trading at stale prices. We show that the hedging (arbitrage) channel is dominant for ATM (ITM) options. Our results highlight the necessity to better understand the costs/risks due to HFT on option markets.
Keywords: market microstructure, high-frequency trading, option market making, hedging, liquidity.
JEL Classification: G14, G18
Suggested Citation: Suggested Citation