THE CROSS-SECTIONAL EFFECTS OF OPTION LISTING ON FIRM STOCK RETURN VARIANCES

We develop a set of hypotheses to explain cross-sectional differences in variance changes associated with option listing. Transactions variance is decomposed into three components: the bid-ask spread, return autocorrelations, and intrinsic variance. Each is investigated separately. We find support for hypotheses that link: (1) changes in dealer transactions costs to changes in the bid-ask spread following option listing; (2) changes in the quantity and quality of information and the value of new information to movements of the return autocorrelation structure toward zero; and (3) changes in trading volume and the clientele that trades the underlying security to changes in intrinsic variance following option listing.     

The Impact of Options Trading on the Market Quality of the Underlying Security: An Empirical Analysis

We find that option listings are associated with a decrease in the variance of the pricing error, a decrease in the adverse selection component of the spread, and an increase in the relative weight placed by the specialist on public information in revising prices for the underlying stocks. We also find that there is a decrease in the spread and increases in quoted depth, trading volume, trading frequency, and transaction size after option listings. Overall, our results suggest that option listings improve the market quality of the underlying stocks.     

Option trading and individual investor performance

This paper examines the impact of option trading on individual investor performance. The results show that most investors incur substantial losses on their option investments, which are much larger than the losses from equity trading. We attribute the detrimental impact of option trading on investor performance to poor market timing that results from overreaction to past stock market returns. High trading costs further contribute to the poor returns on option investments. Gambling and entertainment appear to be the most important motivations for trading options while hedging motives only play a minor role. We also provide strong evidence of performance persistence among option traders.     

Is faster or slower trading better? An examination of order type execution speed and costs

We examine order type execution speed and costs for US equity traders. Marketable orders that execute slower exhibit lower execution costs. Those who remove liquidity faster and pay higher trading costs transact in smaller size, spread trading across more venues, take more liquidity, and are better informed. Nonmarketable limit orders that execute slower exhibit greater adverse selection; and larger, uninformed traders who concentrate their trading in fewer venues submit them. Our findings suggest that slowing down the trading process, when faster options exist, can benefit certain market participants who seek to cross the bid–ask spread.     

DEALER BID-ASK SPREADS AND OPTIONS TRADING ON OVER-THE-COUNTER STOCKS

In this study the impact of option listings on bid-ask spreads for over-the-counter stocks is examined. Option listings are hypothesized to impact spreads by affecting the inventory-holding cost and/or the informed risk component of spreads. Univariate tests reveal that the commencement of options trading is accompanied by a statistically significant decline in percentage spreads. In addition, it is found that there is a significant rise in the average daily stock trading volume in the post-option-listing period, while there is no significant change in variance of the underlying stock returns in the short term. Regression results indicate that some stocks experience a decline in spreads even after controlling for changes in inventory-holding costs. The univariate and regression results taken in conjunction indicate a favorable impact of option listings on both the inventory-holding cost and informed-trading risk components of spread determinants. The combined evidence suggests that initiation of options trading enhances the overall liquidity of the underlying stock.     

Emission Allowance as a Derivative on Commodity-Spread

We provide a valuation formula for emission allowance. Assuming that the value of emission allowance on the last day of a trading phase is equal to a spread of commodity prices (e.g. electricity and natural gas) when the spread is positive and less than the penalty, we show that the emission allowance price is equal to the value of a portfolio of European call options on the spread of the commodities. Using the formula, we obtain a hedging strategy for emission allowance trading. We also empirically analyze option value embedded in emission allowance, and find by numerical analysis that the option value is relatively large.     

The efficacy of regulatory intervention: Evidence from the distribution of informed option trading

A substantive body of equity-market academic research documents an extensive range of costs arising from the SEC’s October 2000 adoption of strictures on selective disclosure and insider trading; suggesting an unusual outcome, specifically, an increase in informed trading. We investigate the efficacy of the SEC’s regulations by examining informed trading in an attractive setting for exploiting private information; the options market. Using data on the S&P 1500 industrial firms, our analysis indicates that about 38% of firms exhibited symptoms of informed option trading prior to regulatory intervention. After regulatory intervention, we observe that only 19% of firms show symptoms of informed trading. In additional testing of ADR firms – explicitly exempt from complying with Reg FD, we find no evidence of a change in informed option trading from pre- to post-regulation; suggesting that the SEC’s strictures on US firms led a to a significant reduction in informed option trading. Notably, our proxies for large shareholder and financial analyst access are associated with the largest decreases in informed option trading. In developing a unique measure of informed trading based on option market data, we provide evidence on the efficacy of security regulation in limiting informed trading.     

Option pricing and the martingale restriction

In the absence of frictions, the value of the under-lying assetimplied by option prices must equal its actual market value.With frictions, however, this requirement need not hold. UsingS&P 100 index options data, I find that the implied costof the index is significantly higher in the options market thanin the stock market, and is directly related to measures oftransaction costs and liquidity. I show that the Black-Scholesmodel has strong bid-ask spread, trading volume, and open interestbiases. Option pricing models that relax the martingale restrictionperform significantly better.     

Trading costs for listed options: The implications for market efficiency

This paper reexamines the anomalous evidence concerning the efficiency of the listed options exchanges. We focus on the structure of trading costs in that market, and note several costs which generally have been ignored, the largest of which is the bid-ask spread. When we adjust the published trading rules for our estimates of these trading costs, the reported abnormal returns are eliminated.     

Trading activity and bid–ask spreads of individual equity options

We empirically examine the impact of trading activities on the liquidity of individual equity options measured by the proportional bid–ask spread. There are three main findings. First, the option return volatility, defined as the option price elasticity times the stock return volatility, has a much higher power in explaining the spread variations than the commonly considered liquidity determinants such as the stock return volatility and option trading volume. Second, after controlling for all the liquidity determinants, we find a maturity-substitution effect due to expiration cycles. When medium-term options (60–90 days maturity) are not available, traders use short-term options as substitutes whose higher volume leads to a smaller bid–ask spread or better liquidity. Third, we also find a moneyness-substitution effect induced by the stock return volatility. When the stock return volatility goes up, trading shifts from in-the-money options to out-of-the-money options, causing the latter’s spread to narrow.     

The Post-Reform Bid-Ask Spread Disparity between Nasdaq and the NYSE

We report further evidence of the difference in execution costs between Nasdaq and the NYSE before and after the 1997 market reforms. We find that informed trading costs are consistently higher on Nasdaq both before and after the reforms. In the pre‐reform period the Nasdaq‐NYSE disparity in bid‐ask spreads cannot be completely attributed to the difference in informed trading costs. However, in the post‐reform period the spread difference between these two markets becomes insignificant with the effect of informed trading costs controlled. Our findings are consistent with the contention that the reforms have largely reduced noninformation trading costs and dealers' rents.     

An empirical examination of the impact of market microstructure changes on the determinants of option bid-ask spreads

This paper examines the determinants of bid-ask spreads in the Australian Options Market before and after it switched from a quote-driven floor-traded market to an order-driven screen-traded market. This study reports that both put and call option bid-ask spreads are positively related to the option's value, its remaining term-to-maturity, its absolute hedge ratio and the volatility of returns from the underlying asset and negatively related to the level of trading activity in that option series. The study also reports that spreads are generally less when market makers are obliged to maintain continuous quotes in the market. The paper also finds that following the change in trading regime, both call and put option spreads became more sensitive to the absolute value of the option's delta. This finding is consistent with previous theoretical and empirical work from equities markets that has suggested that a switch to an electronic trading regime results in an increase in the adverse selection component of the bid-ask spread. There is also some limited evidence that suggests that the switch to electronic trading resulted in call option spreads being less sensitive to the return volatility of the underlying asset but more sensitive to the option's price.     

The liquidity effects associated with addition of a stock to the S&P 500 index: evidence from bid/ask spreads

This study examines changes in stock liquidity, as measured by the bid/ask spread, when a stock is added to the S&P 500 Index. The paper presents evidence of a significant decrease in the bid/ask spread upon S&P 500 addition, however, this effect is limited to only those stocks that were not trading listed options. Further, the decrease in the bid/ask spread for nonoptioned stocks is accompanied by a significant and permanent increase in share price and trading volume. While optioned stocks experience a permanent increase in trading volume, they experience only a temporary increase in share price. The findings for optioned stocks support the hypothesis that the price and volume effects associated with S&P 500 addition derive from temporary price pressure. Findings pertaining to the nonoptioned stocks indicate that the price and volume effects associated with S&P addition reflect enhanced stock liquidity. The decrease in the bid/ask spread for nonoptioned stocks is attributed to informational efficiencies achieved via index arbitrage trading, and it is argued that this effect is mitigated for optioned stocks due to the pre-existence of arbitrage trading between the option and the underlying stock.     

Options and earnings announcements: an empirical study of volatility, trading volume, open interest and liquidity

In this paper we study the impact of earnings announcements on implied volatility, trading volume, open interest and spreads in the stock options market. We find that implied volatility increases before announcement days and drops afterwards. Also option trading volume is higher around announcement days. During the days before the announcement open interest tends to increase, while it returns to regular levels afterwards. Changes in the quoted spread largely respond to higher trading volume and changes in implied volatility. The effective spread increases on the event day and on the first two days following the earnings announcement.     

Liquidity Provision and Noise Trading: Evidence from the "Investment Dartboard" Column

How does increased noise trading affect market liquidity and trading costs? We use The Wall Street Journal's “Investment Dartboard” column, which stimulates noise trading, as a natural experiment to evaluate models of the bid-ask spread. We find that substantial increases in trading volume and significant but temporary abnormal returns occur when analysts recommend stocks in this column, especially when recommendations come from analysts with successful contest track records. We also find an increase in liquidity and a decrease in the adverse selection component of the bid-ask spread.     

Hedging Strategies of Financial Intermediaries: Pricing Options with a Bid-Ask Spread

This paper uses a model similar to the Boyle-Vorst and Ritchken-Kuo arbitrage-free models for the valuation of options with transactions costs to determine the maximum price to be charged by the financial intermediary writing an option in a non-auction market. Earlier models are extended by recognizing that, in the presence of transactions costs, the price-taking intermediary devising a hedging portfolio faces a tradeoff: to choose a short trading interval with small hedging errors and high transactions costs, or a long trading interval with large hedging errors and low transactions costs. The model presented here also recognizes that when transactions costs induce less frequent portfolio adjustments, investors are faced with a multinomial distribution of asset returns rather than a binomial one. The price upper bound is determined by selecting the trading frequency that will equalize the marginal gain from decreasing hedging errors and the marginal cost of transactions.     

Option Pricing and Replication with Transactions Costs

Transactions costs invalidate the Black-Scholes arbitrage argument for option pricing, since continuous revision implies infinite trading. Discrete revision using Black-Scholes deltas generates errors which are correlated with the market, and do not approach zero with more frequent revision when transactions costs are included. This paper develops a modified option replicating strategy which depends on the size of transactions costs and the frequency of revision. Hedging errors are uncorrelated with the market and approach zero with more frequent revision. The technique permits calculation of the transactions costs of option replication and provides bounds on option prices.     

The total cost of trading Belgian shares: Brussels versus London

Since 1990, London’s SEAQ International (SEAQ-I) has attracted considerable trading volume in Belgian equities. This paper investigates competition between the Brussels CATS market and London’s SEAQ-I. Toward this end, we gathered extensive limit order book data as well as transactions and quotation information. With regard to liquidity (indirect costs), measured by the quoted and effective bid–ask spread, the paper concludes that CATS outperforms SEAQ International for both measures. The effective spread is of course substantially smaller than the quoted spread, with the CATS effective spread showing a U-shaped form. This paper, unique in employing an extensive data set that includes all hidden orders and the whole limit order book, produces results in line with the different market microstructure models. Total trading costs on CATS are lower (higher) for small (large) trade sizes.     

Price reversal,transaction costs,and arbitrage profits in the real estate securities market

This paper studies the return reversals of exchange traded real estate securities using an arbitrage portfolio approach. Using the approach, we find that there exist significant return reversals in such securities. These return reversals could be exploited by arbitrage traders if trading costs can be ignored. However, the arbitrage profits disappear after deducting trading costs and taking into account the implicit cost of bid-ask spread. Thus, the real estate securities market is efficient at weekly intervals in the sense that one could not exploit the price reversals via some simple trading rules.     

Market Quote and Spread Component Cost Behavior Around Trading Halts for Stocks Interlisted on the Montreal and Toronto Stock Exchanges

We use intraday quotes and transactions on halted securities that interlisted on the Toronto Stock Exchange and Montreal Exchange to decompose the spreads and examine quote depths. Our results show that order‐processing costs differ for trading halts at the open compared to halts during the rest of the trading day. We find that the adverse‐selection cost component of the spread is higher around trading halts and highest at the trading halt. We also find that print‐media articles that appear within the four‐day window centered on the halt have no impact on the time‐series behavior of the spread cost.