Informed Trading in Stock and Option Markets
Stewart Mayhew, University of Georgia
Sugato Chakravarty, Purdue University
Huseyin Gulen, Virginia Tech

The authors investigate how much price discovery occurs in the option market, and how much in the underlying stock market, using Has brouck’s (1995) method. This method decomposes observed prices into a permanent, random-walk component interpreted as the implied efficient price, and a temporary component due to temporary mis pricing or order imbalances. A market’s share of price discovery is defined as the proportion of innovations to the efficient price occurring in each market. The analysis examines transactions data from ISSM and the Berkeley Options Data Base for a sample of sixty stocks over a period of five years (1988-1992).

Across firms in the sample, the information share attributable to the option market is about 17% with estimates for individual firms ranging from about 12% to about 23%. The authors find evidence that more price discovery occurs in the option market when option volume is higher and stock volume is lower, and when option effective spread are narrower and stock effective spreads are wider. In the cross-section, option market price discovery appears to be greater for high-volatility stocks; however, it tends to be lower on days of extreme positive or negative excess returns. (Accepted Fall 2002.)

Members involved in high frequency trading need to understand where price leadership occurs among the various instruments that depend on essentially the same underlying risks. The results in this study indicate that the contribution of equity options to price information is smaller than that of the underlying stocks.