High-frequency Trading in the Stock Market and the Costs of Option Market Making

59 Pages Posted: 18 Feb 2021 Last revised: 29 Nov 2021

See all articles by Mahendrarajah Nimalendran

Mahendrarajah Nimalendran

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

Khaladdin Rzayev

University of Edinburgh

Satchit Sagade

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

Date Written: January 1, 2020

Abstract

Using a comprehensive panel of 2,969,829 stock-day data provided by the Securities and Exchange Commission (MIDAS), we find that HFT activity in the stock market increases market-making costs in the options markets. We consider two potential channels – the hedging channel and the arbitrage channel – and find that 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 options market-maker to the risk of trading at stale prices. We show that the hedging (arbitrage) channel is dominant for ATM (ITM) options. Given the significant growth in options trading, we believe that our study highlights the need to better understand the costs/risks due to HFT activities in equity markets on derivative markets.

Keywords: market microstructure; high-frequency trading; options market-making; hedging; liquidity *

JEL Classification: G14, G18

Suggested Citation

Nimalendran, Mahendrarajah and Rzayev, Khaladdin and Sagade, Satchit, High-frequency Trading in the Stock Market and the Costs of Option Market Making (January 1, 2020). Available at SSRN: https://ssrn.com/abstract=3776590 or http://dx.doi.org/10.2139/ssrn.3776590

Mahendrarajah Nimalendran

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

P.O. Box 117168
Gainesville, FL 32611
United States

Khaladdin Rzayev (Contact Author)

University of Edinburgh ( email )

Old College
South Bridge
Edinburgh, Scotland EH8 9JY
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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