Identifying Demand and Supply in Index Option Markets

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