Margin Rules, Informed Trading in Derivatives and Price Dynamics
March 2000 UPDATED VERSION
K. John, A. Koticha, R. Narayanan and Marti G. Subrahmanyam
ABSTRACT
We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure
of stock and option markets. In the absence of binding margin requirements, the introduction of an options market
causes informed traders to exhibit a relative trading bias towards the stock because of its greater information
sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements,
their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative
to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without
margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve
market efficiency when stock margins and options margins (relative to stock margins) are sufficiently large or
small but not when they are of moderate size.
Subject: Market/Microstructure; Investments/Derivative
Classification: Theoretical
Subrahmanyam: (212) 998-0348 msubrahm@stern.nyu.edu
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