U. of I. study casts shadow on options trading

Discussion in 'Options' started by nitro, Oct 19, 2005.

  1. nitro


    October 18, 2005

    BY DAVID ROEDER Business Reporter

    How honest is the stock-options market? Newly published research from academics at the University of Illinois said there are times big trading firms manipulate the market to their advantage.

    The manipulation, which is illegal, takes place in the final days before options expire within a given month, said the study published in the October issue of the Journal of Financial Economics.

    The study is the work of finance professor Neil Pearson, associate professor Allen Poteshman and Ph.D. student Sophie Xiaoyan Ni. They based their findings on a mathematical analysis of data from the Chicago Board Options Exchange that covered trading from 1996 through 2002.

    They said big investment banks that trade for both themselves and customer accounts often steer the markets by selling options on specific stocks a few days before expiration. Then, they trade the stock itself so the price finishes "out of the money'' at expiration, meaning the options they sold won't be exercised, the researchers concluded.

    That allows the firms to keep the premiums they collected, which represent the cost of the options they sold.

    "This is an extremely profitable business'' for the investment banks, Pearson said. He said the practice hurts some individual traders, but that more likely victims are market making firms that work the CBOE floor.

    A CBOE spokesman had no immediate comment. It was the leading market for stock options during the years the study covered.

    The researchers also cited benign factors that contributed to stock-market disruptions on option expiration days. Options, which are contracts to buy or sell a stock at a given price, expire on the third Friday of each month, and traders have long noted that the day brings heavy volatility.

    Overall, the value of stocks that have options attached to them changes an average of $9.1 billion on expiration day, the report said.

    The researchers could not say which investment banks engaged in manipulation because the data they saw included only general coding about the sources of the trades. But their information has been sent to the Securities and Exchange Commission, which could follow up with more scrutiny.

    Pearson and Poteshman said nothing in their work indicates options trading is inherently corrupt. But they said they found strong evidence that options trading influences stock prices, an issue that's been a long-term SEC concern.

    Although both professors specialize in options research, they said they don't trade the contracts.

    "Independent of this study, I don't think it makes much sense for retail investors to trade options,'' Pearson said, acknowledging that his view would earn him enemies on La Salle Street.

    Poteshman said options could be useful, but commented, "I would probably think twice before buying an option that expires in a few days.''


  2. Such nonsense should not be even dignified with a response...
    Sell what? Puts or Calls? Trade the underlying? What if another "big" investment bank is doing the opposite? What would you do with the "manipulated" underlying after the expiration? Who says it would not go against you come Monday?
    The spike in the underlying could be explained by simple hedging that some of the "conspirators" or market makers are probably doing... Once again the academia is missing the whole picture...
  3. What a suprise. :eek:

    The proverbial tail that wags the dog... selling vol and defending the strike. Happens routinely in otc markets, but virtually impossible to effect in large caps. Absurd study.
  4. Verdais


    Wow... I can't believe those professors wasted all of that time coming up with a study that I could have told them the results of in one phone call.

    Do the big players in the bund manipulate the futures market to maximize the returns on their options positions? Every single month. We call it pinning and you can set your watch buy it. I hate it and wish they would stop, but I have no idea why it would be illegal. Is selling or buying massive amounts of futures to cover your options position illegal? That's ridiculous. If you have the kind of size that is capable of moving the market... more power to you.

    And to the previous post... its not the market makers that are pushing the market, its the market makers who are getting screwed.
  5. Absolutely agree... the comment was addressing the deriv driving the action in spot, defending the strike, and not the MM's actions. I don't see it as an issue in large cap, index-component vol.
  6. ktm


    Pretty amateur effort as far as studies go. The SEC wouldn't give this a second look, at least not based on this "study".
  7. Those who can, trade.. those who can't, teach and write academic papers about trading based on unrealistic assumptions and exclude human factors in trading...
  8. I was only referring to the market makers' ability to spike up volume on thinly traded underlying when they need to hedge their positions...
  9. It's not illegal to trade based on what your own intentions are. Carl Ichan, or some other big player, can go in and buy or sell all the options they want before they transact in the stock.

    And experienced options players will laugh at this assertion: "The lazy man's way to riches: selling near-term options premium in size." Results might be disastrous.

    Finally, this is another example of a phenomenon that has always amazed me. People supposedly find a repeatable example of some event that will happen in the future - and they are mad about it! If you find such an example you should certainly trade it. In the example given by the professors, if the relationship is so robust, they should sell options ahead of those who are "in the know", and go on to make their fortune.
  10. http://www.thememoryhole.org/corp/finance/sec_amex_report.htm

    Here's a real example of options market abuses.

    It's an internal SEC document concerning illegal behavior at some of the U.S. option exchanges. One exchange was caught red-handed falsifying documents to the SEC to conceal options violations. Unreal.
    #10     Oct 19, 2005