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High-frequency trading in the stock market and the costs of option market making

Author

Listed:
  • Nimalendran, Mahendrarajah
  • Rzayev, Khaladdin
  • Sagade, Satchit

Abstract

Using a comprehensive panel of 2,969,829 stock-day data provided by the Securities and Exchange Commission (MIDAS), we find that HFT activity in the stock market increases market-making costs in the options markets. We consider two potential channels - the hedging channel and the arbitrage channel - and find that HFTs' liquidity-demanding orders increase the hedging costs due to a higher stock bid-ask spread and a higher price impact for larger hedging demand. The arbitrage channel subjects the options market-maker to the risk of trading at stale prices. We show that the hedging (arbitrage) channel is dominant for ATM (ITM) options. Given the significant growth in options trading, we believe that our study highlights the need to better understand the costs/risks due to HFT activities in equity markets on derivative markets.

Suggested Citation

  • 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.
    • Handle: RePEc:ehl:lserod:118885
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    File URL: http://eprints.lse.ac.uk/118885/
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    References listed on IDEAS

    as
    1. Foucault, Thierry & Fresard, Laurent, 2014. "Learning from peers' stock prices and corporate investment," Journal of Financial Economics, Elsevier, vol. 111(3), pages 554-577.
    2. Menkveld, Albert J., 2013. "High frequency trading and the new market makers," Journal of Financial Markets, Elsevier, vol. 16(4), pages 712-740.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    market microstructure; high-frequency trading; options market-making; hedging; liquidity;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G00 - Financial Economics - - General - - - General

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