Option Market and Stock Market

In discussing the relationship between option market and sock market, the most studies focus on the issue of the Price Discovery. The Price Discovery, meaning when the market accepts new information, investors will make a judgement based on it and trade in financial market by that, then asset would adjust rapidly to its equilibrium price by market mechanism.

Namely, from formulation of diffusion of information to investors' interpretation and trading, the course which assets price reach equilibrium in succession can be called the Price Discovery. The Price Discovery is a characteristic of efficient market that causes market price to contain all information sufficiently and immediately. Thus, it accounts for Dominant market and Price lead-lag relationship.

In the Perfect Market, perfect substitute attribute make asset has only one price because when price discrepances come about, the arbitrage opportunity is appeared at once. In other words, under the arbitrage action, there is no lead-lag relationship between stock and option market. In fact, there are several kinds of trading cost in real market and dissimilar market microstructures in different asset markets. Therefore, information transmission is inconsistency making variance of price movement. Besides, in the imperfect market, information might be exposed by trading actions, so any news is implied in a dominant market foremost.

Past evidence on the lead-lag relation between option and stock prices has been almost US based. It is however often conflicting. Early literatures found that stock options lead the underlying stocks. Manaster and Rendleman (1982) adopted 172 stocks with listed options and 805 trading days. They examine close-to-close returns of portfolios based on the relative difference between stock and option prices and find that closing option prices contain

information that is not contained in closing stock prices. However, a serious problem results from the use of closing data, since the Chicago Board Options Exchange (CBOE) closes ten minutes after the close of the stock market. It is possible that the additional information contained in closing option prices merely reflects more recent rather than better information.

Bhattacharya (1987) in order to overcome the three major limitations of MR, namely, (a) daily closing stock and option prices, (b) their non-simultaneity, and (c) the non-consideration of bid/ask spreads for stocks and options, he used the raw data which contains a record for each transaction and another for each bid/ask update for every option series. He compares implied bid/ask stock prices (calculated from call option prices) to actual bid/ask stock prices to calculate arbitrage opportunities. The stock is considered underpriced (overpriced) if the implied bid (ask) is higher (lower) than the actual ask (bid). A simulated trading strategy based on these arbitrage signals indicates that profits are insufficient to cover transaction costs for all intraday holding periods. However, the Manaster and Rendleman (1982) results are confirmed by Bhattacharya’s finding of statistically significant excess returns for overnight holding periods. Bhattacharya’s test design however suffers in that it only detects whether the option market leads the stock market and not vice versa. Although Bhattacharya recognises this as a problem, the reverse simulations are not performed and although he knows the problem, he didn’t resolve all doubts.

Anthony (1988) required two data-selecting criterions. One is that the call option and their underlying common shares are listed contemporaneously for period from January 1, 1982 through June 30, 1983, and the other is that sample firms must be listed on either the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX). He uses daily data to examine whether trading in one market causes trading in the other. His analysis is based on econometric tests for causality derived from the work of Granger (1969). Anthony concludes that trading in call options leads underlying assets by one day. However, he finds

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this to be the case for only thirteen firms, whereas stock volume leads option volume for four firms and no unambiguous direction exists for eight firms. Anthony’s results are subject to the same caveats as Manaster and Rendleman due to the non-simultaneity of the closing times for the two markets.

Stephan and Whaley (1990) conceived that the approach must circumvent two major problems of the previous studies. First, transaction-by-transaction data from the stock and option markets are used. Thus, the biases inherent in the non-simultaneity of closing prices in the two markets are avoided. Second, the analysis focuses directly on the lead/lag relation between the intraday price changes in the stock and option markets rather than indirectly through simulating a trading strategy. They examine empirically the intraday price change transformed into implied stock price changes over five-minute intervals and trading volume relations between stocks and options for a sample of firms whose options were actively traded on the CBOE during the first quarter of 1986. They use multi-variable time series regression analysis to estimate the lead/lag relation between the price changes and trading volume in the option and stock markets. Inconsistent with earlier studies, they find that trading in the stock market leads the option market about fifteen to twenty minutes on average both in terms of price changes and trading activity.

Chan, Chung and Johnson (1993) first confirm Stephan and Whaley’s results using data for the same period of analysis and then show their results can be explained as spurious leads induced by infrequent trading of options. Specifically, they show that the stock price lead disappears when the average of the bid and ask prices is used instead of transaction prices.

They also show that minimum price variation rules contribute to the documented stock lead because they cause greater discreteness for the trading of options, since stock and option price movements have a non-linear relationship.

Chan, Chung, and Fong (2002) argued that although Stephan and Whaley (1990)

investigate both price changes and volume in the two markets, they analyze the price change relationship and the volume relationship separately. Thus, they provides a comprehensive analysis of the interdependence of net trade volume (buyer-initiated trading volume minus seller-initiated trading volume) and quote revisions for actively traded NYSE stocks and their CBOE-traded options.They show that stock net trade volume, but not option net trade volume, predicts contemporaneous and subsequent stock and option quote revisions, suggesting that informed investors initiate trades in the stock market only. On the other hand, option quote revisions, as well as stock quote revisions, predict subsequent quote revisions in the other market.