Identifying Demand and Supply in Index Option Markets

We identify latent demand and supply in index option markets using a sign-restricted VAR and highlight the bias from treating (equilibrium) net demand as exogenous. Market-maker supply and end-user demand are far from infinitely elastic as assumed by some models, but elasticities exceed existing estimates for equities. Characterizing supply and demand provides insights into the structure of index option markets. Deteriorating market conditions are associated with increasing option demand and decreasing option supply. The ATM (OTM) markets for calls and puts are mainly driven by demand (supply), and ATM demand and OTM supply of calls predict option and S&P500 returns.