Option Pricing in Markets with Informed Traders

TL;DR

This paper extends the Black-Scholes-Merton model to markets with informed traders, incorporating their private information into option pricing, and estimates related implied surfaces from market data.

Contribution

It introduces new models for option pricing with informed traders in complete markets, addressing the discontinuity puzzle and estimating implied informational surfaces.

Findings

Extended Black-Scholes-Merton model for informed traders

Estimated implied probability and return surfaces from market data

Resolved the discontinuity puzzle in option pricing

Abstract

The objective of this paper is to introduce the theory of option pricing for markets with informed traders within the framework of dynamic asset pricing theory. We introduce new models for option pricing for informed traders in complete markets where we consider traders with information on the stock price direction and stock return mean. The Black-Scholes-Merton option pricing theory is extended for markets with informed traders, where price processes are following continuous-diffusions. By doing so, the discontinuity puzzle in option pricing is resolved. Using market option data, we estimate the implied surface of the probability for a stock upturn, the implied mean stock return surface, and implied trader information intensity surface.