High-frequency trading (HFT) involves using advanced algorithms and high-speed data networks to trade stocks quickly, and whilst HFTs aim to capitalise on tiny price discrepancies that exist for very short periods, they also play a role in providing liquidity to the market by being ready to buy and sell at any given moment.
The study, led by Dr Khaladdin Rzayev, focuses on understanding how these rapid trading activities influence the ‘bid-ask spread’ in the options market. ‘Bid-ask spread’ is the difference between the price at which sellers are willing to sell and the price at which buyers are willing to buy. A key finding of this paper was that increased HFT activity in the stock market leads to wider bid-ask spreads in the options market, making it more expensive for people to trade options. This happens for two main reasons: First, there is ‘latency arbitrage’ where aggressive HFTs exploit time lags between the stock and options markets to make profits. This forces options market makers to increase their spreads to protect themselves from potential losses. Second, when there is informed trading in the options market, we see a simultaneous increase in aggressive HFT activity in the stock markets and the bid-ask spread in the options market.
In this latest research, the team highlight the complex relationship between stock and options markets, showing that HFT can have broader effects beyond the markets where it directly operates. ‘To the best of our knowledge, this is the first study to show that HFT activity in stock markets impacts options market liquidity,’ said Rzayev. ‘Additionally, another novel finding of this paper is that HFTs transmit information between the options and stock markets.’
Khaladdin Rzayev is a Senior Lecturer in Finance at our School.