Identifying Demand and Supply in Index Option Markets

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See all articles by Kris Jacobs

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Anh Thu Mai

University of Houston - C.T. Bauer College of Business

Paola Pederzoli

University of Houston - C.T. Bauer College of Business

Date Written: June 21, 2022

Abstract

We identify latent demand and supply in the market for index options using a VAR with sign restrictions. The time series of latent demand conveys important economic insights that are not evident from the analysis of equilibrium quantities. Using observable proxies for risk, we find that demand shifts right and supply shifts left when risk is high. While the market for ATM options is mainly demand-driven, the market for OTM options is mainly supply-driven. The price impact of trade is much larger than (downward-biased) existing estimates, but market-makers provide substantial liquidity, even during crises. ATM call option demand and OTM call option supply forecast future delta-hedged option returns and S&P500 returns.

Keywords: Latent Demand, Demand and Supply Elasticity, Index Options, Intermediaries, Market-Makers, Net Demand Pressure, Pure-Sign Restricted VAR, Covid-19 Crisis, Financial Crisis

JEL Classification: G01, G13, G14, G20

Suggested Citation

Jacobs, Kris and Mai, Anh Thu and Pederzoli, Paola, Identifying Demand and Supply in Index Option Markets (June 21, 2022). Available at SSRN: https://ssrn.com/abstract=

Kris Jacobs

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Anh Thu Mai (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Paola Pederzoli

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

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