Option Market Characteristics and Price Monotonicity Violations

• Author: Doojin Ryu,Hyung‐Suk Choi,Heejin Yang
• Date: 01 May 2017
• Published date: 01 May 2017
• DOI: http://doi.org/10.1002/fut.21826

Option Market Characteristics and

Price Monotonicity Violations

Heejin Yang, Hyung-Suk Choi, and Doojin Ryu*

This study reexamines whether option price monotonicity properties hold in a liquid market

with little market friction and considers the validity of the monotonicity properties in light of

option market characteristics. We confirm that option prices do not monotonically correlate

with underlying spot prices and that call and put prices often increase or decrease together,

indicating that the monotonicity properties are not consistent with the observed option price

dynamics. The violations of monotonicity properties are associated with not only market

microstructure effects, trade sizes, and option leverage but also other market characteristics

such as trade direction, individual investor demand, foreign investor trading, and market

volatility. Violation occurrences tend to be clustered, and their relationship with option market

characteristics has not been affected by the recent market reform. © 2016 Wiley Periodicals,

Inc. Jrl Fut Mark 37:473–498, 2017

1. INTRODUCTION

Options are representativefinancial derivatives widely used for speculation, hedging, and risk

management.Assuming the absence of arbitrage opportunities(at least theoretically), the price

increase for an underlying asset should result in instant price increases (decreases) for its

corresponding call (put) options; this price relationship among underlying spots and options

communicates important trading indications to options traders suchas speculators, hedgers,

and arbitrageurs. Given this relationship, Bakshi, Cao, and Chen (2000) define the

comprehensive price monotonicity properties that option price dynamics should satisfy and

illustrate three basic criteria of option price dynamics. The first criterion notes a compulsory

monotonicincrease (decrease) in call (put) pricesin response to an increase in the price of their

underlying asset (i.e., the monotonicity characteristic).The second criterion posits that,when

the uncertainty for all option price changes originates totally from underlying spot price

changes, the result should be a perfectly correlated price relationship among options of the

same type and between an option and its underlying asset (i.e., the characteristic of perfect

Heejin Yang is a Ph.D. candidate at the College of Economics, Sungkyunkwan University, Seoul, Korea.

Hyung-Suk Choi is an associate professor at Ewha School of Business, Ewha Womans University, Seoul,

Korea. Doojin Ryu is a tenured professor at the College of Economics, Sungkyunkwan University, Seoul,

Korea. The authors are grateful for the helpful comments and suggestions from Robert I. Webb (editor),

Soosung Hwang, Jaeram Lee, and the members of Sungkyunkwan University (SKKU) Economic Research

Institute (ERI). This work was supported by the National Research Foundation of Korea Grant funded by the

Korean Government (NRF-2014S1A5B8060964).

JEL Classification: G13, G15

*Correspondence author, College of Economics, Sungkyunkwan University, 25-2, Sungkyunkwan-ro, Jongno-gu,

Seoul 03063, Republic of Korea. Tel: þ82-2-760-0429, Fax: þ82-2-760-0950, e-mail: sharpjin@skku.edu

Received May 2016; Accepted October 2016

The Journal of Futures Markets, Vol. 37, No. 5, 473–498 (2017)

© 2016 Wiley Periodicals, Inc.

Published online 22 November 2016 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21826

correlation). The third criterionindicates that underlying and risk-free assets should allow for

replicating options;hence, the options should be redundant securities (i.e.,the characteristic

of option redundancy).

In light of these option market characteristics, this study reexamines whether the option

price dynamics observed in a highly liquid market with little market friction are consistent

with the criteria described above. Studies testing the empirical validity of the monotonicity

property

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of option prices claim that these criteria are frequently violated in real-world

financial markets and that option prices often do not move as predicted by traditional one-

dimensional diffusion option pricing models. Such violations indicate that the option pricing

models are not consistent with empirically observed option price dynamics and that option

prices are not perfectly correlated with underlying spot prices and thus the options are not

redundant securities. Analyzing the trade and quote (TAQ) dataset of S&P 500 options,

Bakshi et al. (2000) empirically test whether the monotonicity property holds in the US

market. They show that the prices of call options move in a direction opposite to that of their

underlying asset price 7.2–16.3% of the time and that the underlying spot and put prices

move in the same direction 5.4–15.7% of the time. They also find that the violations of the

monotonicity property are related to time decay and/or microstructure factors such as bid-ask

spreads, trading volume, and the number of quote revisions. Dennis and Mayhew (2009)

conduct simulation tests based on the US market and argue that, when option prices are

noisy, a significant portion of the violations is due to microstructural noises.

Violations of the monotonicityproperty of option price dynamics are not confined to the

US options market. Recent studieson worldwide options markets find that the violations may

be a universal phenomenonin both developed and emerging optionsmarkets. Perignon (2006)

examines the transaction prices of five distinct option products on the European (DJ EURO

STOXX-50), British (FTSE 100), French (CAC 40), German (DAX), and Swiss (SMI) stock

indices, finding that the sampled intraday option prices violate the monotonicity property 6–

35% of the time. Perignon (2006) attributes the frequent violations of the monotonicity

property to marketmicrostructure and tactical trading effects,suggesting that these violations

are related to underlyingasset returns, intraday periods, transaction-day-of-the-week priority,

and illiquidity.Analyzing the Taiwanese index options market,Lin, Chen, and Tsai (2011) find

that the sampled intraday call (put) prices violate the monotonicity property 39.7–57.0%

(30.0–56.5%)of the time, depending on the option contracts consideredand sampling interval.

Following the approachof Bakshi et al. (2000), Sim, Ryu, and Yang (2016) explorean intraday

dataset of KOSPI 200 index options, finding that option prices in Korea often do not

monotonically correlate with underlying spot prices and that call (put) prices move in a

direction opposite (identical) to that of the underlying index 18.78% (17.79%) of the time.

Though previous studies report significant violations of option price monotonicity, they

do not clearly identify which option market variables and characteristics explain them. Most

of the studies claim that the violations are caused by market microstructural noises and

overlook other possibilities. For example, Bakshi et al. (2000) argue that the violations are

related to bid-ask spreads, tick sizes, and option premiums’time decay. Lin et al. (2011) and

Perignon(2006) attribute the violations to tactical trading effects and microstructure factors.

Dennis and Mayhew (2009) suggest that much of the violations are influenced by

microstructural biases. Though Sim et al. (2016) recently report a partial link between

investor demand and violations, they ignore the role of various investor types and fail to

consider the violations in terms of the information quality of options trading.

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Bakshi et al. (2000) explain that the monotonicity property can include perfect correlation and option redundancy

properties, as the latter two properties do not hold when option prices do not monotonically move with the underlying

asset price changes. Therefore, this study uses the term monotonicity property for its representativeness.

474 Yang, Choi, and Ryu