Heavy option trading creates a feedback loop that forces market makers to buy high and sell low, turning stable markets unstable.
While we think of derivatives as following the stock market, this paper shows they can actually take the wheel. It identifies a 'Stability Gap' where speculative option flows force the middle-men of the market to amplify price swings rather than dampening them, explaining how meme-stock style spikes happen endogenously.
Market Instability from Option Flows
SSRN · 6447643
We develop a theoretical and simulation-based framework to show how speculative option trading can generate price instability in the market for the underlying asset. The model features fully funded investors with downward-sloping demand, option traders who continually reinvest their gains in leveraged call positions, and a rule-based market maker who clears both asset and option markets while remaining deltahedged. When volatility is underpriced or speculative flows are large relative to the und