An Emprical Analysis of Directional and Volatility Trading in Options Markets

Abstract

Considerable research in the area of “market micro structure” focuses on the problem faced by market makers who are obliged to quote firm prices and trade with all comers, even when some of the traders they face will have access to valuable information that they do not know. For an optional stock, there are two classes of information about which way the stock price is likely to move next, and volatility information, relating to the likely size of the price move, which is most important for options trading. The two types of information have different implications for market makers in the stock and the options. In this article, Cherian and Weng investigate the extent to which trading activity in a stock and its options can provide insight into which type of information traders are currently active, and, then, how prices and bid-ask spreads respond in the different situations.