High-frequency trading in the stock market and the costs of option market making

Nimalendran, Mahendrarajah, Rzayev, Khaladdin and Sagade, Satchit (2022) High-frequency trading in the stock market and the costs of option market making. Systemic Risk Centre Discussion Papers (113). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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Abstract

Using a comprehensive panel of 2,969,829 stock-day data provided by the Securities and Exchange Commission (MIDAS), we find that HFT activity in the stock market increases market-making costs in the options markets. We consider two potential channels - the hedging channel and the arbitrage channel - and find that HFTs' liquidity-demanding orders increase the hedging costs due to a higher stock bid-ask spread and a higher price impact for larger hedging demand. The arbitrage channel subjects the options market-maker to the risk of trading at stale prices. We show that the hedging (arbitrage) channel is dominant for ATM (ITM) options. Given the significant growth in options trading, we believe that our study highlights the need to better understand the costs/risks due to HFT activities in equity markets on derivative markets.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.systemicrisk.ac.uk/
Additional Information:	© 2022 The Author(s)
Divisions:	Systemic Risk Centre
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	G - Financial Economics > G1 - General Financial Markets > G10 - General G - Financial Economics > G0 - General > G00 - General
Date Deposited:	29 Jun 2023 15:45
Last Modified:	16 Sep 2023 00:00
URI:	http://eprints.lse.ac.uk/id/eprint/118885

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