High-frequency trading in the stock market and the costs of option market making

Mahendrarajah Nimalendran, Khaladdin Rzayev and Satchit Sagade

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: Using a comprehensive panel of 2,969,829 stock-day data provided by the Securities and Exchange Commission (MIDAS), we find that HFT activity in the stock market increases market-making costs in the options markets. We consider two potential channels - the hedging channel and the arbitrage channel - and find that HFTs' liquidity-demanding orders increase the hedging costs due to a higher stock bid-ask spread and a higher price impact for larger hedging demand. The arbitrage channel subjects the options market-maker to the risk of trading at stale prices. We show that the hedging (arbitrage) channel is dominant for ATM (ITM) options. Given the significant growth in options trading, we believe that our study highlights the need to better understand the costs/risks due to HFT activities in equity markets on derivative markets.

Keywords: market microstructure; high-frequency trading; options market-making; hedging; liquidity (search for similar items in EconPapers)
JEL-codes: G00 G10 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2022-01-17
New Economics Papers: this item is included in nep-mst and nep-rmg
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