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D. Muravyev, “Order Flow and Expected Option Returns,” (University of Illinois at Urbana-Champaign, 12 November 2011, presented by Dimitriy Muravyev at the OptionMetrics User Conference 2012).

D. Muravyev, “Order Flow and Expected Option Returns,” (University of Illinois at Urbana-Champaign, 12 November 2011, presented by Dimitriy Muravyev at the OptionMetrics User Conference 2012).

Abstract: 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 asymmetric-information 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 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.