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Price Discovery in the U.S. Stock Options Market

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Price Discovery in the U.S. Stock Options Market Price Discovery in the U.S. Stock Options Market YUSIF E. SIMAAN AND LIUREN WU YUSIF E. SIMAAN In the U.S., several exchanges with different market the Securities and Exchange Commission is an associate professor of microstructure designs compete to provide quotes and (SEC) approved a plan to electronically link finance in the Graduate attract order flow on a common set of stock options. the various market centers (the “Linkage School of Business at Fordham University in In this article, we analyze how the different Plan”). The SEC has also adopted more strin- New York, NY. microstructure designs affect the price discovery of gent quoting and disclosure rules on the options [email protected] options quotes and how they alter the flow of options market. The “firm quote” rule was applied to trading activities over time. We find that the fully the options markets on April 1, 2001. LIUREN WU electronic exchange system at the International Secu- At the time of our study, five options is an associate professor of rities Exchange (ISE), where several market makers exchanges compete to provide quotes and economics and finance in the Zicklin School of provide quotes independently and anonymously to attract order flows on a common set of stock Business, Baruch College at compete for order flow within the exchange, generates options: the American Stock Exchange the City University of New options quotes that are the most informative and the (AMEX), the Chicago Board of Options York in New York, NY. most executable, with the narrowest bid–ask spreads. Exchange (CBOE), the International Securi- [email protected] Over time, the ISE’s leading quote quality has ties Exchange (ISE), the Pacific Stock attracted order flow to the exchange, and has com- Exchange (PCX), and the Philadelphia Stock pelled other exchanges to pursue technology Exchange (PHLX). The five exchanges differ innovations and structural reforms through either in both histories and market microstructure expansion or consolidation. designs. AMEX, CBOE, PCX, and PHLX are all floor-based exchanges that have been in existence since the 1970s. The AMEX and he financial industry has come to the PHLX apply a specialist structure resem- recognize the importance of deriv- bling that used in the stock market. The ative securities in providing unique CBOE and the PCX trade options under a investment opportunities and risk- modification of the open outcry structure used Tmanagement vehicles. Trading volume on in the futures pit, where one primary or lead derivatives has increased tremendously during market maker works with several market the past few years. Accompanying this expan- makers on the floor to make the market. The sion in derivatives have been rapid expansions roles of the primary market maker are similar and transformations in the stock options to those of a specialist, except that options IT IS ILLEGALmarket. TO In REPRODUCE the United States, in an effortTHIS to ARTICLEtraded under the IN primary ANY market FORMAT maker can reduce trade-throughs and other market seg- also be traded by other market makers. By mentations, a series of regulatory changes have contrast, the ISE is a relatively new entity, taken place since the late 1990s. In July 2000, which started its first day of options trading 20 PRICE DISCOVERY IN THE U.S. STOCK OPTIONS MARKET WINTER 2007 Copyright © 2007 on May 26, 2000. It is a fully electronic exchange without among multiple market makers. The relative ranking of a physical floor. For each option series, one primary maker the four floor-based exchanges further shows that current and several competitive market makers send in quotes order flows also affect the incentives of an exchange in pro- independently and anonymously via their respective viding binding quotes. Market makers facing more order quoting engines. These quotes are consolidated via a cen- flows have stronger incentives to provide binding quotes. tralized consolidating system and compete internally for Over time, higher quote quality also attracts order order flows directed to the exchange. flow. Consistent with its leading quote quality, since its In this article, we analyze how the different inception the ISE has rapidly been gaining market share. microstructure designs affect the price discovery of the By mid-2003, the market share of the ISE had become options quotes from different exchanges and how they the largest in options trading volume, excluding the Stan- alter the flow of options trading activities over time. Based dard and Poor’s (S&P) index options which are solely on the real-time feeds from the Options Price Reporting licensed to the CBOE. Its rapid rise in market share high- Authority (OPRA) during January of 2002, we choose lights the economic benefits of technology innovation 39 stocks that have the highest options trading volume and careful microstructure design, and has spurred a new during that month. At each of the 20 business days in that wave of technology innovation and structural reforms month, we extract both the quotes and trades on the most among both old and new options exchanges. actively traded option series on each of the 39 stocks. We Compared to the vast market microstructure liter- measure the Hasbrouck [1995] information share by using ature on the stock market, there has been little research the second-by-second quote book, and we analyze the on the market microstructure and price discovery of the relation between price discovery and other market con- options market. The few known empirical microstructure ditions. We also investigate the general statistical proper- studies on the options market include Battalio, Hatch, ties of the bids and asks from each exchange and analyze and Jennings [2004]; Chakravarty, Gulen, and Mayhew how they match with the transactions. [2004]; de Fontnouvelle, Fishe, and Harris [2003]; Our analysis shows that among the five options Holowczak, Simaan, and Wu [2006]; Mayhew [2002], exchanges, quotes from the ISE have the highest infor- and Neal [1987, 1992]. None of these studies directly mation share estimates on average. The difference becomes addresses the issue of price discovery among different more pronounced when the options series have higher options exchanges. aggregate trading activities. Among the four floor-based exchanges, the modified outcry systems at the CBOE and THE MARKET MICROSTRUCTURE the PCX provide more informative quotes than the spe- OF THE OPTIONS EXCHANGES cialist systems at the AMEX and the PHLX. These find- ings suggest that intra-exchange competition from multiple Option prices provide information about the under- market makers enhances the informativeness of the options lying security that is not readily available from the primary quotes, and quote source anonymity enhances the intra- security market. The price quote of a stock represents a exchange competition. mean valuation, but the prices of options underlying the We also find that quotes from the ISE have the nar- stock—with the whole spectrum of strike prices and rowest mean bid-ask spreads. Among the four floor-based maturities—present a complete picture of the conditional exchanges, the two larger exchanges, the AMEX and the distribution of the stock value at different possible real- CBOE, deliver quotes with narrower bid-ask spreads than izations and conditioning horizons. Therefore, it is impor- do the two smaller exchanges, the PHLX and the PCX. tant to understand the information flow in the options Finally, quotes from the ISE are also the most executable: market and to appreciate the fact that price discovery in Transactions at the ISE occur exactly at the bid or offer the options market is not limited to the discovery of the for 84% of time, the highest among all five options underlying stock price. The importance of options price exchanges. The percentage drops to 57% for AMEX, 40% discovery analysis goes far beyond the stock price dis- for CBOE, 39% for PCX, and 36% for PHLX. Since covery studies among the underlying stock markets (e.g., many specialists on the floor exchanges are also compet- Hasbrouck [2003]), or between stock and options mar- itive market makers at the ISE, we attribute the ISE’s nar- kets (e.g., Chakravarty, Gulen, and Mayhew [2004] and rower bid-ask spread to intra-exchange competition Holowczak, Simaan, and Wu [2006]). WINTER 2007 THE JOURNAL OF DERIVATIVES 21 Copyright © 2007 Market making on options also has a unique set of in the futures pit. The PCX also follows a similar modi- characteristics. First, the counterparty risk of options fied outcry structure and trades options under a Lead contracts is separate from the underlying company. In the Market Maker (LMM). The responsibilities of the DPM U.S., exchange-listed options are subject to a formal or LMM include disseminating quotes, providing liquidity clearing procedure by the Options Clearing Corporation to thin markets by trading on his own account, and rep- (OCC). All options exchanges are members of the OCC. resenting public limit orders. The roles are similar to those Second, underlying a single stock are hundreds of options of a specialist. The difference is that options traded under at different strike prices and maturities. The values of a DPM may also be traded by other market makers. How- these options are inherently linked by no-arbitrage rela- ever, the DPM maintains the right to a certain percentage tions. When a market maker adjusts the quote on one of the public order flow (Mayhew [2002]). option contract, the market maker should also consider In contrast to the four floor-based exchanges, market the quotes on other options underlying the same stock to making on the ISE is fully electronic and is not on a phys- avoid being locked into an arbitrage trading program. ical floor. Market makers transmit their quotes via their The options market maker must also pay constant quoting engines.
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