Who Offers Liquidity on Options Markets when Volatility is High?

Abstract

In this paper, we investigate the relationship between volatility of and liquidity provision through the aggregation of high-frequency data on the stock index option markets of Taiwan. Strong evidence shows the different behaviors of liquidity supply for market makers and nonmarket makers. In addition, evidence demonstrates that nonmarket makers are unwilling to offer liquidity on buy-side when option price is high, but the phenomena are not evident for the market makers. Overall, nonmarket makers provide less liquidity when volatility is high. In contrast, market makers provide the same or more liquidity on the limit order book when volatility is high. Therefore, the market makers play more important a role when market is volatile. The policy implication is that professional market makers on option markets are stable forces to offer liquidity when market is volatile, and it is referable for those pure order-driven option markets without market makers (e.g., Korea Exchange, KRX).