Dynamic Hedging and Order Flow Dynamics

The price process in a financial market is driven by demand and supply. Statistical analyses have shown that price “feeds back” on future demand and supply. To date, few testable models have been proposed that offer an economic explanation for this relationship. In this paper, we investigate a mechanism that might, at least to some extent, explain the positive feedback effect of prices on future order volume, namely dynamic hedging. Using order book and transaction data from the Swiss Stock Exchange and Eurex, we investigate the dependencies between theoretical hedging demand generated by option holders and actual order volume in the underlying stock market. We are able to show that the popular belief that options trading has a negative systematic impact on the underlying market in the form of a positive feedback does not seem to be warranted.