Options market makers׳ hedging and informed trading: Theory and evidence

Sahn-Wook Huh, Hao Lin and Antonio S. Mello

Journal of Financial Markets, 2015, vol. 23, issue C, 26-58

Abstract: We develop a model to analyze the effects of hedging activities by options market makers (OMMs) facing informed trading. The model suggests that OMMs׳ hedging activities motivated by adverse-selection risk lead to wider spreads in both stock and options markets. The hedging effect on spreads is more pronounced in the options market than in the stock market. The effect is larger when the OMMs hedge with the underlying asset than with other options. In addition, hedging activities by the OMMs significantly alter the trading strategies of informed traders. Our empirical tests provide evidence consistent with the key implication of our model.

Keywords: Options market making; Hedging; Informed trading; Adverse-selection risk; Bid–ask spreads; Daily conditional probability of informed trading (search for similar items in EconPapers)
JEL-codes: D82 G10 G14 (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finmar:v:23:y:2015:i:c:p:26-58

DOI: 10.1016/j.finmar.2015.01.001

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