Identifying Demand and Supply in Index Option Markets

Abstract

We identify latent demand and supply in index option markets using a sign-restricted VAR and highlight the bias from treating (equilibrium) net demand as exogenous. Market-maker supply and end-user demand are far from infinitely elastic as assumed by some models, but elasticities are higher than existing estimates from equity markets. As market conditions deteriorate, option demand shifts right and supply shifts left. The ATM (OTM) market is mainly driven by demand (supply), and ATM demand and OTM supply of calls predict option and S&P500 returns. Disentangling supply and demand is essential to understanding the structure of the index option markets.