The Impact of Options Trading on the Market Quality of the Underlying Security: An Empirical Analysis

Authors

  • Raman Kumar,

    1. R. B. Pamplin College of Business, Virginia Tech
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  • Atulya Sarin,

    1. Leavey School of Business, Santa Clara University
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  • Kuldeep Shastri

    1. Katz Graduate School of Business, University of Pittsburgh
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    • * R. B. Pamplin College of Business, Virginia Tech; Leavey School of Business, Santa Clara University; and Katz Graduate School of Business, University of Pittsburgh; respectively. This paper was formerly titled “The Impact of Options Trading on the Market Microstructure of the Underlying Security.” We would like to thank Michael Brennan, Gregory Kadlec, Dilip Shome, Vijay Singal, René Stulz (the editor), Sunil Wahal, and an anonymous referee for their comments and suggestions. Earlier versions of the paper were presented at the 1993 European Finance Association Conference, the 1993 Financial Management Association Conference, the 1993 Queen's University Conference on Derivatives, and Virginia Polytechnic Institute and State University. Kumar gratefully acknowledges financial support through a summer research grant from the R. B. Pamplin College of Business at Virginia Polytechnic Institute and State University. Sarin acknowledges financial support from the Dean Witter Foundation.

ABSTRACT

We find that option listings are associated with a decrease in the variance of the pricing error, a decrease in the adverse selection component of the spread, and an increase in the relative weight placed by the specialist on public information in revising prices for the underlying stocks. We also find that there is a decrease in the spread and increases in quoted depth, trading volume, trading frequency, and transaction size after option listings. Overall, our results suggest that option listings improve the market quality of the underlying stocks.

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