Order Flow and Expected Option Returns
Social Science Research Network
The paper presents three pieces of evidence that the inventory risk faced by market-makers has a primary effect on option prices. First, I introduce a simple method for decomposing the price impact of trades into inventory-risk and asymmetricinformation components. The components are inferred from the difference between price responses of the market-maker who receives a trade and those who do not. Both price impact components are significant for option trades, but the inventory-risk component
... ry-risk component is larger. Second, using the full panel of option daily returns an instrumental variable estimation finds that option order imbalances attributable to inventory risk have five times larger impact on option prices than previously thought. Finally, past order imbalances have more predictive power than a set of fifty other plausible predictors of future option returns. * I thank the members of my dissertation committee: Tim Johnson, Mao Ye and Prachi Deuskar. I am especially grateful to my advisor, Neil Pearson, for his support, wisdom and extensive discussions we had.