Does buying pressure affect the smile of FTSE 100 Index options? Implied volatility functions and net buying pressure: evidence around the Brexit referendum

Abstract

Using the Brexit referendum event as an exogenous setting, this study examines the presence of implied volatility smile phenomena in the FTSE 100 Index options market, and whether imbalances between supply and demand for options across the five different moneyness categories affect the shape of the implied volatility function (IVF). In particular, using the net buying pressure hypothesis of Bollen and Whaley (2004), the research investigates the relation between buying pressure on FTSE 100 Index options and changes in corresponding implied volatility levels. FTSE 100 Index options are the most commonly-used instrument for investors to take speculative leverage positions and manage risk on the UK equity market. Thus, the demand for these options through speculative and hedging activities during the years 2015-2017 mirrors market sentiment towards UK equities, and thus Brexit, during these years.

The analysis component of the research entails modelling the Black-Scholes-derived prices and implied volatilities of options, identifying net buying pressure patterns by inferring trade direction using the Bulk Volume Classification procedure, and conducting OLS regression tests to measure the significance of the relation between net buying pressure and changes in implied volatility.

The study finds that the IVF of FTSE 100 Index options exhibits a smirk shape attributable to an inverse relationship between implied volatility and strike price. Moreover, the study finds empirical evidence on the relation between options trading activity and changes in implied volatility, and documents that changes in implied volatility are dominated by the excess demand for call options which tends to be particularly pronounced during the post-Brexit referendum period. Finally, the study finds that daily changes in implied volatility are in most cases transitory, indicating price reversals, as liquidity providers gradually rebalance their positions as a response to the excess demand for options created by volatility traders.