Informed Trading in Stock and Option Markets

We investigate the contribution of option markets to price discovery, using a modification of Hasbrouck’s (1995) “information share” approach. Based on five years of stock and options data for 60 firms, we estimate the option market’s contribution to price discovery to be about 17% on average. Option market price discovery is related to trading volume and spreads in both markets, and stock volatility. Price discovery across option strike prices is related to leverage, trading volume, and spreads. Our results are consistent with theoretical arguments that informed investors trade in both stock and option markets, suggesting an important informational role for options. INVESTORS WHO HAVE ACCESS to private information can choose to trade in the stock market or in the options market. Given the high leverage achievable with options and the built-in downside protection, one might think the options market would be an ideal venue for informed trading. If informed traders do trade in the options market, we would expect to see price discovery in the options market. That is, we would expect at least some new information about the stock price to be reflected in option prices first. Establishing that price discovery straddles both the stock and options markets is important for several reasons. In a frictionless, dynamically complete market, options would be redundant securities. This paper contributes to the understanding of why options are relevant in actual markets, by providing the first unambiguous evidence that stock option trading contributes to price discovery in the underlying stock market. Further, we document that the level ∗Chakravarty is from Purdue University; Gulen is from the Pamplin College of Business, Virginia Tech; and Mayhew is from the Terry College of Business, University of Georgia and the U.S. Securities and Exchange Commission. We would like to thank the Institute for Quantitative Research in Finance (the Q-Group) for funding this research. Gulen acknowledges funding from a Virginia Tech summer grant and Mayhew acknowledges funding from the Terry-Sanford Research Grant at the Terry College of Business and from the University of Georgia Research Foundation. We would like to thank the editor, Rick Green; Michael Cliff; Joel Hasbrouck; Raman Kumar; an anonymous referee; and seminar participants at Purdue University, the University of Georgia, Texas Christian University, the University of South Carolina, the Securities and Exchange Commission, the University of Delaware, George Washington University, the Commodity Futures Trading Commission, the Batten Conference at the College of William and Mary, the 2002 Q-Group Conference, and the 2003 INQUIRE conference. The U.S. Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This study expresses the authors’ views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.