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Market Making in the Options Markets and the Costs of Discrete Hedge Rebalancing

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  • Jameson, Mel
  • Wilhelm, William

Abstract

In this paper, the authors provide empirical evidence consistent with the hypothesis that options market makers face risks in managing inventory that are unique to the options market. In particular, they show that risks associated with the inability to rebalance an option position continuously and uncertainty about the return volatility of the underlying stock each account for a statistically and economically significant proportion of the bid-ask spreads quoted for a sample of Chicago Board Options Exchange options. Copyright 1992 by American Finance Association.

Suggested Citation

  • Jameson, Mel & Wilhelm, William, 1992. "Market Making in the Options Markets and the Costs of Discrete Hedge Rebalancing," Journal of Finance, American Finance Association, vol. 47(2), pages 765-779, June.
    • Handle: RePEc:bla:jfinan:v:47:y:1992:i:2:p:765-79
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    Citations

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    Cited by:

    1. John Kambhu, 1998. "Dealers' hedging of interest rate options in the U.S. dollar fixed-income market," Economic Policy Review, Federal Reserve Bank of New York, vol. 4(Jun), pages 35-58.
    2. Clancey-Shang, Danjue, 2023. "COVID lockdown, Robinhood traders, and liquidity in stock and option markets," International Review of Financial Analysis, Elsevier, vol. 90(C).
    3. Oliver Entrop & Georg Fischer, 2020. "Hedging costs and joint determinants of premiums and spreads in structured financial products," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(7), pages 1049-1071, July.
    4. Giovanni Petrella & Reuben Segara, 2013. "The bid--ask spread of bank-issued options: a quantile regression analysis," Quantitative Finance, Taylor & Francis Journals, vol. 13(8), pages 1241-1255, July.
    5. Cakici, Nusret & Goswami, Gautam & Tan, Sinan, 2014. "Options resilience during extreme volatility: Evidence from the market events of May 2010," Journal of Banking & Finance, Elsevier, vol. 49(C), pages 262-274.
    6. Benjamin M. Blau & Tyler J. Brough, 2014. "Short Sales and Option Listing Decisions," Financial Management, Financial Management Association International, vol. 43(3), pages 703-724, September.
    7. Nimalendran, Mahendrarajah & Rzayev, Khaladdin & Sagade, Satchit, 2024. "High-frequency trading in the stock market and the costs of options market making," LSE Research Online Documents on Economics 124228, London School of Economics and Political Science, LSE Library.
    8. Wu, Wei-Shao & Liu, Yu-Jane & Lee, Yi-Tsung & Fok, Robert C.W., 2014. "Hedging costs, liquidity, and inventory management: The evidence from option market makers," Journal of Financial Markets, Elsevier, vol. 18(C), pages 25-48.
    9. Cao, Jie & Han, Bing, 2013. "Cross section of option returns and idiosyncratic stock volatility," Journal of Financial Economics, Elsevier, vol. 108(1), pages 231-249.
    10. Naomi Boyd, 2015. "Market making and risk management in options markets," Review of Derivatives Research, Springer, vol. 18(1), pages 1-27, April.
    11. Gunther Capelle-Blancard & Mo Chaudhury, 2007. "Price clustering in the CAC 40 index options market," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00265668, HAL.
    12. Saikat Nandi, 1995. "Asymmetric information about volatility and option markets," FRB Atlanta Working Paper 95-19, Federal Reserve Bank of Atlanta.
    13. Atmaz, Adem & Basak, Suleyman, 2019. "Option prices and costly short-selling," Journal of Financial Economics, Elsevier, vol. 134(1), pages 1-28.
    14. John Kambhu, 1997. "Interest rate options dealers' hedging in the US dollar fixed income market," Research Paper 9719, Federal Reserve Bank of New York.
    15. Chunbo Liu & Cheng Zhang & Zhiping Zhou, 2018. "From funding liquidity to market liquidity: Evidence from the index options market," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 38(10), pages 1189-1205, October.
    16. Pirjetä, Antti & Ikäheimo, Seppo & Puttonen, Vesa, 2010. "Market pricing of executive stock options and implied risk preferences," Journal of Empirical Finance, Elsevier, vol. 17(3), pages 394-412, June.
    17. Nimalendran, Mahendrarajah & Rzayev, Khaladdin & Sagade, Satchit, 2022. "High-frequency trading in the stock market and the costs of option market making," LSE Research Online Documents on Economics 118885, London School of Economics and Political Science, LSE Library.
    18. Chang‐Mo Kang & Donghyun Kim & Junyong Kim & Geul Lee, 2022. "Informed trading of out‐of‐the‐money options and market efficiency," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 45(2), pages 247-279, June.
    19. Dmitriy Muravyev & Neil D Pearson & Stijn Van Nieuwerburgh, 2020. "Options Trading Costs Are Lower than You Think," The Review of Financial Studies, Society for Financial Studies, vol. 33(11), pages 4973-5014.
    20. Sasha Stoikov & Mehmet Sağlam, 2009. "Option market making under inventory risk," Review of Derivatives Research, Springer, vol. 12(1), pages 55-79, April.
    21. Huh, Sahn-Wook & Lin, Hao & Mello, Antonio S., 2015. "Options market makers׳ hedging and informed trading: Theory and evidence," Journal of Financial Markets, Elsevier, vol. 23(C), pages 26-58.
    22. Entrop, Oliver & Fischer, Georg, 2019. "Hedging costs and joint determinants of premiums and spreads in structured financial products," Passauer Diskussionspapiere, Betriebswirtschaftliche Reihe B-34-19, University of Passau, Faculty of Business and Economics.
    23. Griffith, Todd & Roseman, Brian & Shang, Danjue, 2020. "The effects of an increase in equity tick size on stock and option transaction costs," Journal of Banking & Finance, Elsevier, vol. 114(C).
    24. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.

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