Option Order Imbalance as a Measure of Aggressive Trading Direction
Summary
The document defines option order imbalance (OOI) as a stock-level measure of signed option trading, adjusted for option delta and scaled by shares outstanding. Each trade contributes according to its estimated initiating side, its sensitivity to the underlying, and its size. The measure is introduced in the context of studying whether option order flow conveys information about stock prices.
The question asks why executed trades need a buy or sell sign, since every trade has both a buyer and seller. The response distinguishes the passive limit order resting on the book from the aggressive market order that initiates execution. Trade imbalance aggregates this initiator direction, indicating whether buyers or sellers are crossing the spread; it does not count both counterparties as separate signals. Trade signing depends on algorithms, so the measure can be noisy or misclassified, and an imbalance by itself does not prove informed trading or predictive power.
Key ideas
- OOI signs each option trade by its estimated initiating side and weights it by delta and trade size.
- Shares outstanding provide a scale adjustment for comparing imbalance across stocks.
- Each execution has a buyer and seller, but trade imbalance tracks which side acted aggressively.
- Trade signing algorithms infer initiator direction and can introduce classification error.
- An order imbalance may reflect directional pressure but does not by itself demonstrate informed trading or stock return predictability.
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Full text
# Option order imbalance
# Option order imbalance
Currently studying the paper:
HU, Jianfeng. Does Option Trading Convey Stock Price Information?. (2014). Journal of Financial Economics. 111, (3), 625-645. Research Collection Lee Kong Chian School Of Business.
To test the impact of option order flow affects stock order flow. Author defines the measure of option order imbalance:
$\text{OOI}_{it}=\frac{\sum_{j=1}^{N} 100\text{ Dir}_{itj}\text{Delta}_{itj}\text{Size}_{itj}}{\text{Num_Shares_Outstanding}}$
Where, The option order imbalance,$\text{OOI}_{it}$, is measured for stock i on day t. $\text{Dir}_{itj}$ is a dummy variable equal to 1 if the jth option trade on stock i is initiated by the buyer, and -1 if the trade is initiated by the seller, according to certain trade signing algorithms.$\text{Delta}_{itj}$ is the option price sensitivity to the underlying stock price, and $\text{Size}_{itj}$ denotes the trade size in option lots (100 shares of the underlying stock).
My question is:
If option trade denotes an executed trade, why do we need the dummy variable? Shouldn't buy trades be cancelled out by sell trades? Since whenever one buys someone else sale the respective quantity( price differs due to bid-ask spread).
## Answer by python_enthusiast (score 3)
https://quant.stackexchange.com/a/44427
There are two main types of orders: limit orders and market orders.
#### Limit Orders:
Limit orders are passive orders that are placed on the book at a given price, and remain there until they are executed or cancelled.
#### Market Orders:
Market orders are executed immediately at the best available price in the book, against a limit order that is already there.
#### Imbalance:
When we talk about book imbalance, we are looking at the imbalance between bid and ask prices, thus we are looking at the imbalance between limit orders. However, when we say trade imbalance, we are looking at the imbalance between market orders. Trade imbalance gives us a more "real-time" indicator of the trading direction, and also a stronger signal about informed traders' decisions.
#### Dummy Variable:
When you say "buy trades and sell trades cancel out", you actually mean a limit order and a market order have different directions (one is buying, the other is selling or vice-versa). However, when you want to know towards which side the market is actually moving, you want to know the aggregate direction of the market orders. This is why you need the dummy variable to indicate if it is an aggressive buy (market order to buy being executed against a limit order to sell) or an aggressive sell (market order to sell being executed against a limit order to buy).Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.