Informed Option Trading Strategies

Download or read book Informed Option Trading Strategies written by Cyriel de Jong and published by . This book was released on 2004 with total page 35 pages. Available in PDF, EPUB and Kindle. Book excerpt: 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.