Informed Option Trading Strategies

Cyriel de Jong

ERIM Report Series Research in Management from Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam

Abstract: We use a sequential trade model to clarify two mechanisms following the introduction of an option that may lead to increased efficiency in the underlying. On the one hand, market makers learn from trades in the option market and set more accurate prices. On the other hand, the proportion of informed traders in the stock market may be altered depending on the informed traders' strategies. If insiders trade a larger fraction than uninformed traders in the stock, for example because the immediate profits in the stock are larger, spreads in the stock widen, and price errors may increase. This reduces the efficiency increase from the 'learning' effect, possibly to the extent that overall efficiency deteriorates. We use simulations to analyze the resulting impact in a dynamic setting. For realistic parameter values we find that option trading leads to lower price errors in the underlying. The more popular options are, the more quickly information is incorporated in the underlying prices. However, uninformed traders do not necessarily benefit from this speedier convergence. Their stock performance crucially depends on the insider's trading strategy and the fraction of informed trading.

Keywords: Options; asymmetric information; leverage; market efficiency; price discovery (search for similar items in EconPapers)
JEL-codes: G13 G3 M (search for similar items in EconPapers)
Date: 2001-10-18
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