The Role of Signal Precision and Transaction Costs in Stock, Option and Volatility Trading

Abstract

In this study, we examine the rationale that informed traders use in choosing various financial instruments in order to speculate on the volatility of the underlying asset, here a common stock. Using a continuous-time trading model, we demonstrate that the quality of the private information regarding the volatility parameter together with the relative transaction costs observed in the various segments of the cash and derivatives markets will determine informed agents’ trading habitats. We further show that in the presence of imprecise volatility signals, only the “most sophisticated” traders (those with highly precise volatility signals) will engage in pure volatility bets. Traders with less precise signals will choose a naked option strategy, while traders at the low spectrum of the precision scale will invest in the underlying stock. Thus, the low volume of pure volatility trades observed by Lakonishok et al. (2007) does not necessarily imply that only fringe traders have chosen to speculate on volatility. Rather, it may suggest that the majority of informed traders do not have precise volatility signals.