Publication Type
Working Paper
Version
publishedVersion
Publication Date
9-2023
Abstract
This paper demonstrates that option market maker hedging impacts the liquidity of underlying stocks. Options contracts have zero net supply, and option market makers engage in delta hedging to manage the risk of their net imbalances, unlike option end-users. Consequently, when option market makers hold a net short (long) position, their dynamic hedging demands liquidity from (or supplies liquidity to) the underlying stock, leading to market destabilization (or stabilization). Leveraging proprietary option exchange data that categorizes option trading by trader type, we document this effect and show that it is stronger for stocks where liquidity supply is expected to be limited.
Keywords
derivatives, liquidity, feedback effects
Discipline
Finance and Financial Management | Portfolio and Security Analysis
Research Areas
Finance
First Page
1
Last Page
49
Identifier
10.2139/ssrn.4567604
Citation
O′Donovan, James; YU, Yang; and ZHANG, Jinyuan Zhang.
Option market maker hedging and stock market liquidity. (2023). 1-49.
Available at: https://ink.library.smu.edu.sg/lkcsb_research/7870
Copyright Owner and License
Authors
Creative Commons License
This work is licensed under a Creative Commons Attribution-NonCommercial-No Derivative Works 4.0 International License.
Additional URL
https://doi.org/10.2139/ssrn.4567604