The Information Content of Option Trading and Liquidity Risk

This paper presents strong evidence to show that stock liquidity and option liquidity play important roles in explaining the information content of options trading for future stock returns. Using implied volatility skew to capture the option trading activity of informed traders, we provide a clear and negatively predictive linkage between option trading and stock returns. The negatively predictive relation between options trading activity and stock returns is particularly accentuated for stocks with lower liquidity. This shows that lower levels of stock liquidity increase the amount of informed trading activity in the option market, and stock is slow to incorporate information embedded in option trading activities. In addition, the predictive ability of option trading activity tends to increase with option liquidity, for each level of stock liquidity. The empirical results are sufficiently robust for different liquidity measures