Options, particularly short-dated ones, are gaining popularity among retail traders, with their trading volume increasing significantly. While some research argues that short-dated options do not impact the market, certain market practitioners hold opposing views.
Reference [1] investigated the risks associated with short-dated options order flow. It examined the effective trading costs of short-dated options, exploring their connection to intraday order flow distribution with the goal of identifying risky patterns that could disrupt a market with high trading volumes. The authors pointed out,
Our analysis documents economically and statistically significant positive relationship between intraday order flow volatility and illiquidity in options market, particularly for ultra-short term options.The effect is pervasive: it holds in the time-series and cross-sectional dimension, and it significantly outweighs the significance of more traditional daily first-moment measures of order flow dynamics, such as volumes or absolute order imbalances. Furthermore, it also outweighs the significance of traditional measures capturing the delta-hedging needs of market makers. These findings suggest that liquidity providers rely primarily on active inventory rebalancing and trade matching throughout the day, with the main source of inventory risk arising from providing liquidity to unbalanced order flows. An exchange-specific analysis further shows that liquidity providers are averse to unpredictable order flows even when they do not directly absorb them, highlighting the role of indirect costs and future liquidity provision risk in the observed relationship.
Our findings underscore the potential risks posed by high volumes in short-term option contracts, which can amplify intraday order flow volatility and challenge market stability. We show that as intraday order flow volatility rises, liquidity providers widen bid-ask spreads to manage the elevated risk, resulting in higher hedging costs for investors increasingly dependent on short-term rollover strategies over long-term hedges. This spread widening, in turn, can impair market efficiency by reducing liquidity and price discovery, which may in turn elevate systemic risk…
In summary, the study finds that,
- Liquidity providers primarily focus on active inventory management and trade matching, using delta-hedging as a secondary risk management strategy.
- Additionally, intraday options order flow has become more volatile since the financial crisis.
- The impact of order flow volatility diminishes with longer maturities, emphasizing the heightened liquidity sensitivity of ultra-short-maturity options.
Ultimately, the study concludes that short-dated options order flow can increase illiquidity, raise trading costs, and destabilize the market.
Let us know what you think in the comments below or in the discussion forum.
References
[1] Pederzoli, Paola and Doshi, Hitesh and Sert, Saim Ayberk, Risky Intraday Order Flow and Equity Option Liquidity (2024). https://ssrn.com/abstract=5006194
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