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

Abstract

We investigate the impact of high-frequency trading (HFT) in equity markets on options market liquidity. We find that an increase in volume originating from aggressive trading strategies employed by HFTs in the stock market is associated with higher bid-ask spreads in the options market. This relationship is largely driven by options market makers’ quotes being exposed to sniping risk by HFTs attempting to profit from put-call parity violations. In addition, we show that this relationship is causal by using the introduction of flash orders by NASDAQ as an exogenous shock to HFT in the stock market.

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

JEL Classification: G14, G18