Information flows and option bid/ask spreads

This study analyzes two types of information flows in financial markets. The first type represents return information, where informed investors know whether the stock price will increase or decrease. The second type is labeled volatility information, where the direction of the stock price is unknown, but informed investors know that the stock price either will increase or decrease. Both information flows are estimated within the GARCH framework, approximated with the use of Swedish OMX stockindex and options strangle return shocks, respectively. The results show significant conditional stock‐index and options strangle variance, although with notable differences. Stock‐index return shocks exhibit a high level of variance persistence and an asymmetric initial impact to the variance. Option strangle shocks have a relatively low persistence level, but a higher and more symmetric initial impact. A time‐series regression of call and put option bid/ask spreads is performed, relating the spreads to the information flows and other explanatory variables. The results show that call and put option bid/ask spreads are related to stock‐index and options strangle return shocks, as well as the conditional stock‐index variance. This is consistent with the view that market makers alter option spreads in response to return and volatility information flows, as well as the conditional stock‐index variance.© 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:1147–1172, 2005