Physica A 527 (2019) 121067

Contents lists available at ScienceDirect

Physica A
journal homepage: www.elsevier.com/locate/physa

High-frequency trading: Inverse relationship of the financial

markets
∗
Khuram Shafi a , , Natasha Latif a , Shafqat Ali Shad b,c , Zahra Idrees d
a
Department of Management Sciences, COMSATS University Islamabad, Wah Campus, Pakistan
b
Department of Computer Sciences, IOWA State University, USA
c
Department of Computer Sciences, Luther College Decorah IOWA, USA
d
Department of Business Administration, Huazhong University of Science and Technology, Wuhan, China

highlights

• To compute option price derivatives, i.e., the ‘Greeks,’ Monte Carlo simulation estimators are used.
• For option pricing Comparison is made between the Black–Scholes and the stochastic volatility models with jumps.
• To generate unbiased estimates of option price derivatives, compare the path wise and likelihood ratio approaches.
• Try to get simulation estimators and numerical results for some path-dependent and path-independent options.
• Possible suggestions for speculation strategies and risk management are briefly discussed.

article info a b s t r a c t

Article history: Integration of financial markets due to globalization generates new paradigms of
Received 29 October 2018 financialization. And with HFT i.e. the high-frequency trading, financialization has
Available online 10 May 2019 distorted the relations of financial markets. HFT is based on highly complex financial
products such as Index Options which are linked with volatility and it‘s forecasting.
Keywords:
High-frequency trading After the introduction of Volatility, VIX Index of Chicago Board of Options Exchange
Arbitrage trading becomes the effective benchmark for stock market volatility now a day. Although VIX
Financialization Index is a volatility measure derived from Standard and Poor 500 Index (SPX) option
Volatility Index prices, traders are unaware of the inverse relationship between these markets. This study
Standard, and poor index 500 purpose is to understand the relationship between the two trading vehicles and increase
Financial markets the market awareness based on high order moment models which are used to mimic the
behavior of these index options. It also explains the logic versus perception perspective
in option pricing theory to develop theoretical foundations and consider it in future
theory erection. Finding shows that SPX index is negatively correlated with VIX Index
and financial markets have an inverse relationship between them.
© 2019 Elsevier B.V. All rights reserved.

1. Introduction

Due to globalization, an ever-increasing growth has been observed in financial markets from the last few decades.
Securitization and globalization of financial markets and their manipulations are directly affecting capital markets. These
are associated with a financial cost of the firm [1]. This phenomenon is known as ‘Financialization’, which signify the

∗ Corresponding author.
E-mail addresses: drkhuramshafi@ciitwah.edu.pk (K. Shafi), natasha.latif@outlook.com (N. Latif), shadsh01@luther.edu (S.A. Shad),
Zahra.idrees.butt@gmail.com (Z. Idrees).

https://doi.org/10.1016/j.physa.2019.121067
0378-4371/© 2019 Elsevier B.V. All rights reserved.
2 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067

importance of financial markets in the economy by using advance computerization techniques [2,3]. ‘‘Financialization’’
is somehow like ‘‘globalization’’, a suitable term for many discrete operational and major changes in the financial world.
Alike globalization, financialization also cause changes which are inter-linked and tend to have similar consequences in
the distribution of power, income, and wealth, and in the pattern of economic growth [4].
It was indicated that the ‘‘financialization’’ is the increasing role of computerized trading, technological advances,
financial motives, financial institutions in the operation of the domestic and international economies and the regulatory
changes which drove the emergence of High-Frequency Trading (HFT) [5,6]. In last three decades, financial market
underwent a number of crises which caused an intensive argument about the functions of rules and regulations.
Technological advancement in financialization has altered the way of trading, now new trading technologies have been
used in the financial market and one of them is arbitrage trading and HFT [7]. Both trading includes the financial activities
where market makers generate excessive profit by using highly complex financial products, such as swaps, futures, and
options. Using computerization in the financial market for HFT play a significant role, in this perspective financial crises
appearance because of mispricing and the way information in one market affect the other market become a complex
phenomenon [8]. This article deals with HFT and the inverse relationship of financial markets that use a complex financial
product such as Index Options (VIX & SPX).

2. Paradigm of finance in program trading

‘Finance’ is the most successful field of economics in terms of theory and pragmatic work. After the appearance
of ongoing financial, social and economic crisis, market makers were called for the reconsideration of management
and finance theories [9]. In order to investigate the reasons behind the recent financial crisis, it is been necessary to
understand their underlying worldviews [10]. Increasing financial crisis cause the expansion of financial sector to use
more sophisticated financial products. This extraordinary sophistication of financial products and the exceptional speed
of financial transactions have intensely changed the relationship between financial markets [3,11,12].
Financial markets, as complex systems may adopt algorithm models which follow diversified theories, therefore they
work like other complicated systems [13]. Towards the end of nineteen century, it is been significant for financial markets
to adopt new trading technologies [14]. Because financial theories are moderating as the time passes and these theories
are revolving around a set of strong assumptions therefore whenever market adopt new variable they directly affect
manipulations of a financial institution [7]. Manipulations of financial intuitions lead towards market imperfections and
increase the financial cost for participants. These manipulations include program trading and this program trading is called
‘Index Arbitrage’. Hedgers and institutional investors used this strategy for pursuing index arbitragers [15]. But the point
to ponder here is that the program trading is the reason of 1987 stock market crash and a decline in many markets, this
happens because of the of trader’s desire to trade many stocks at the same time [16,17]. 1987 crash capture the attention
of many researchers to the famous pricing theory of finance i.e. the ‘Option-Pricing theory’ whose central assumption is
that the volatility remains constant throughout the life of option contract which is untrue in practice [18–20].
World first electronic market open by NASDAQ in 1971, began the concept of program trading which causes the
financial markets be to very liberalized and fragmented [21]. Since the pricing of an underlying is a big concern for
every trader. Adopting program trading in electronic exchange allow investors to buy and sell complex financial products
without human interference. Reasons behind using program trading in the field of finance are that traders demand is
increasing day by day to trade a large quantity of stock at the same time and to reduce the chance for arbitragers by
avoiding the complex financial product price discrepancies [6].
In 1973, this practice was undergoing by another very famous electronic market, that is the Chicago Board Options
Exchange (CBOE) which adopt the formula proposed by Black, Scholes, and Merton known as ‘Black–Scholes formula’
for option pricing. This formula is used as a benchmark in options markets and it may lead to a boom in trading
options [22]. Black–Scholes formula provides mathematical legitimacy to CBOE, but it may also incur losses in some other
market, because of the lack of the risk management [23,24]. Therefore, market participants used BS model after some
standardization. These standardizations do not guarantee profits but may reduce the risk of loss, but instead of all this
trader used this formula as a benchmark because it provides the price that is fairly close to the model price. Instead of all
these standardizations and limitations a well know discrepancy was observed in option pricing theory is the appearance
of ‘option smile’ in 1987 crash [25].
In sum up, this discrepancy occurs because of the program trading, overvaluation, illiquidity, and market psychology,
which that the electronic market technological advancement and circulation of information in the market are somehow
the reasons of the explosion of program trading [26]. Such unparalleled difficulty makes a considerable case for connecting
academic finance with the other social sciences. Concurrently, the ongoing economic, social and ecological crisis has led
several finance scholars to argue that a significant diversification of methods, concepts and practical tools established in
academic finance is needed to move on towards computerization because of the increasing importance of financial market
in economy [3,10,27–31].
 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067 3

Fig. 1. Review model.

3. Financialization and computerization

‘Financialization’ is the notion that signifies that the increasing importance of the field of finance in an economy [32].
Because of the globalization, the market efficiency is increasing day by day and now financial markets and institutions
motive is to increase the growth of activities associated with the financial cost [6]. Financial institutions deregulation
in 1970’s causes the push towards ‘‘productization’’, also by describing all the values in financial terms. Although, the
purpose is the creation of markets for virtually everything i.e. computerization. But the critics argue that this phenomenon
damage the market efficiency. Also, computerization of markets may allow institutions to make and exploit information
asymmetries and difficulties in ways that rise investors cost [33].
On the relationship of financialization and computerization significant literature exists. For example, how national
economies growth and profits get affected due to financialization? [34], how new types of devices and indexes have
improved investment? [35] and whether financialization and computerization as a process are workable in the long
term [36]. Because of increasing financialization the usage of program trading and computerization is also growing. The
cornerstone of the literature on dealing with the computerization of financial markets [37–40]. Growing computerization
of financial market creates a ‘‘hyper-reality’’ about the financial cost of underlying. Using computers for recording
financial transactions may allow the formation of complex databases which activated a remarkable development of
financial econometrics. In today’s financial market for managing operating risk through hedging and speculation ‘‘Financial
Derivatives’’ become very widespread (see Fig. 1).
In the mid-nineteenth century, the market of financial derivative originated and started to grow rapidly till the 20th
century. Derivatives are money related diverse instruments such as options, futures, and swaps whose role is to allow
efficient and effective transfer of risk rather than a transfer of value that is the thing that they are used for. Through
derivatives, financial globalization encourages the diversification of investment and the transfer of risk, because of this
globalization and securitization its usage has been increased significantly and now chiefly they are utilized for eliminating
risk [41,42].
In the operations of modern corporations, derivatives are deeply embedded and over the last few years options
market experienced a tremendous growth because organizations accepting volatility as an asset class. And because of
this volatility, different anomalies appear over the time, therefore, it becomes very important to understand that how
options are priced among markets, also how the market works. Performance of market is a function of various outside
parameters and volatility is one of them [18]. The fast growth of the options market in 1970’s brought quickly a lot of data
on the platform and simulate an impressive development of research in this area. Although academics and practitioners
have shown interest in the debate as to whether or not derivatives increase or decrease the financial stability. [43].

4. High-frequency trading and information technology

Since 1980’s, in the trading implementation of computerization and financialization became a significant part of Wall;
later on, critics blamed it for exacerbating the assumptions of option pricing theory and the stock market crash in October
1987 [44]. Implementation of both techniques i.e. the computerization and program trading cause the emergence of HFT.
As the time passes this thought was provoked and in 1998, Securities Exchange Commission (SEC) introduced a new
platform named as ‘‘Regulation of Exchanges & Alternative Trading Systems’’ where the comparison is made between
different exchanges through electronic trading [45].
Researchers in 2000, indicate that this electronic comparison and change in quoting style may cause spreads to appear
in between the bid and ask prices and it also may affect the assumption of business models of market makers [21].
Technological innovation in the form of high-frequency trading (HFT) triggered our attention to examining volatility
among financial markets. Finally, the SEC’s Regulation National Market System announced that they should quote prices
on international level instead of quoting them on a national level, this difference in prices generate an opportunity for
arbitragers [46].
Who get benefit from discrepancies in the prices of a stock at different exchanges? Subsequently, today’s markets
are fragmented, comprising different exchanges very frequently literature reflects the influence of ‘speed technology’
4 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067

on financial trading and market liquidity [2,47–49]. There is very less research on the relationship between HFT and
market liquidity. The main phenomena that exist between financial market and the information technology are known as
High-Frequency Trading. After the appearance of crashes, many studies create an argument about the HFT positive and
negative effects [44,50–52]. HFT helps these fragmented markets work efficiently as one, but it also exacerbates problems
at times of market stress by dramatically speeding up the HFT. It is projected that 50 per cent of stock trading in the USA
is determined by HFT [53]. The pervasive effects of information technology on numerous industrial sectors like finance
over several decades provide an even stronger case for multidisciplinary academic research which links themes, issues
and critical debates [2].

5. Volatility transmission among financial markets

Over the last few years’ index options market has experienced a tremendous growth. This comes about because
organizations accepting volatility as an asset class i.e. securities exhibit similar characteristics. Due to the appearance of
different anomalies over the time, it becomes very important to understand that how market integrates with each other.
Financial world history is filled with volatility shocks causing prices to change; probably the most shocking instance was
the Great Crash of 1929, known as the Great Depression when monthly realized volatility rose above 100%. Then in 1987
when the stock market crash, an anomaly was observed at that time the predecessor of volatility index (VIX), reached
levels of more than 150%. This collapse of the global stock market in 1987, raised questions about the validity of constant
volatility assumption of option pricing theory [54].
In last decade, biggest crisis in the history appears in 2007–08 where markets for the first time observe the highest level
of volatility. In pricing derivatives, these crises prove the importance of volatility [55]. Volatility is an important element
in financial markets, which helps in understanding the price dynamics of underlying price governed by the stochastic
process [56]. In economics and finance, a contagion effect can be taken as a situation where a volatility shock in a particular
market spreads out and affect another market by the way of, say, price movements. There is strong evidence that this
contagion effect occurs due to change in volatility and thus causing it to transfer to other markets as well [54].
For instance, volatility contagion effects include the ‘‘transmission’’ of volatility from one market to another, meaning
that idiosyncratic changes in one market can be transferred into the other market [57]. Blake explained that the October
1987 crash appeared because of the volatility changes thus, volatility can explain extreme events [41]. For asset pricing
models, volatility has an extensive variety of work applications from pricing exotic derivatives [58]. It was also claimed
that volatility can be used as a measure of market efficiency, he investigates the efficient market models involving different
volatility process [59]. Later on, it was observed that volatility dynamic can be applied to macroeconomic variables of any
market, whereas the stock market is a well-known important indicator [23]. Naturally prices of one specified asset changes
depending on different reasons. Financial engineers are interested in the ways these changes occur. They try to design
different mathematical & financial models which can help them to determine the optimal buying or selling price for a
given asset [60].

6. Information tradeoff between stock return and volatility

It becomes very important to check the information trade-off of HFT among volatility and the stock returns in any
financial market. In finance theories, a popular belief seems to be that there is a positive relationship between a stock
return and volatility. A significant body of finance theories and their pragmatic evidence relates the return on an asset
to the notion of variance. For example, the theoretical pricing models relate the direct change in the price of the asset to
its own variance, or to the covariance between its return and the return on a market portfolio [19,61]. Empirical study
attributed much of the decline in stock prices during the 1970s to increases in volatility [1,62], while it was argued that
the increases in volatility were not persistent enough to cause the decline [63].
Another most important pragmatic formalized fact about volatility is the ‘‘leverage effect’’, which indicate the negative
correlation of stock returns and the change in volatility [64]. This term ‘‘leverage’’ was used while explaining the
phenomena of correlation by using the standard normal distribution [65]. Also, it is a challenge for researchers because
volatility is uncertain and is not observable but the fact is that researchers observed this negative correlation between
two variables i.e. stock return and volatility [66]. For financial securities boundaries between nation markets are now
narrowed and now they have a large amount of price data historical data, trading volumes and recording of financial
transactions available on regulated exchanges. Investors used this information as a tool to model the market behavior of
underlying prices and develop or adopt strategies to optimize ROI return on investments, also try to reduce the exposure
of risk of investing in these securities with volatility [67].
Understanding the relationship of information tradeoff between these two vehicles (volatility and the stock prices),
this study took a look at the relationship between the SPX, the S & P 500 index and the VIX, the Chicago-volatility-index.
Given the importance of the flow of volatility among market and so much literature supporting and investigating the
theme, this paper intentions is to provide inclusive coverage of the status of this investigation. Enchanting an effective
viewpoint, we carefully review the methodology and empirical findings in different research papers. The influence of
this study is to deliver a bird’s eye view of the negative correlation between volatility and stock return among different
markets and to offer some recommendations for the practice and future research.
 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067 5

7. Background on VIX and SPX500

7.1. Black–Scholes model

In 1973, Black and Scholes proposed the Black–Scholes Formula for pricing Futures in their paper ‘‘The pricing of
Options and corporate liabilities’’ (Black & Scholes, 1973; Cohen et al. 1972). Which brought a massive change in the
capital market and this was the first time when people know how to make a value for derivatives (i.e. options). This
formula has been introduced for the purpose of pricing a European Option on a given stock which does not pay any
dividend before the strike price and other related custom derivatives. For the price of a non-dividend paying European
call option, the Black–Scholes equation is described as:
C (S , t ) = SN (d1 ) − Ke−r (T −t ) N(d2 )
where:
C (S, t) = Price of a Call Option
S = current stock price at time t
N (d) = value of cumulative normal distribution
K = strike price
r = rate of interest
T = maturity of underlying
(T − t) = duration of the option
σ 2 = Volatility
( ) ( )
ln KS + r + σ2 (T − t)
2

d1 = √
σ (T − t)
√
d2 = d1 − σ (T − t)
When the Black–Scholes equation was first published, it was under the following assumptions, The stock return
volatility is constant over time. On the other hand the logarithm of the stock price follows the stochastic process
dS = µSdt + σ sdz, with fixed µ & σ . No tax and transactions cost. During option life No dividends are paid. There
are no riskless arbitrage opportunities. The option is European style options. The risk-free rate is same for all maturities
and the interest rate is constant. Efficient Market, the Black–Scholes assumes that markets are perfectly liquid, and it is
possible to purchase or sell any amount of stock or options.

7.2. The S & P 500 index (SP 500)

The Standard and Poor’s 500 Index abbreviated as SP500 is a weighted stock index which is the combination of 500
companies from the North American stock market. SP500 contains the 500 largest companies using market capitalizations,
which means the value of outstanding stocks. It is designed to measure the performance of the American equity markets
(Bloomberg).
In 1923, the Standard & Poor’s, a partition of The McGraw–Hill Companies offered its first primary stock market index
named as ‘S&P 90 Index’. Later, on March 4, 1957, after few alterations the S&P 90 index was changed into the S&P500
Index (SPX) representing and tracking the performance of an inclusive spectrum of the US stock market (see Fig. 2).
In mid-2004, for index calculation purposes, Standard & Poor’s considered using only ‘‘freely floating shares’’ that
exclude shares held by insiders, founding families, or governments which are not available for investors to purchase.
To get SP500, the standard & poor’s committee choose US based companies, which are trade on two largest American
stock market exchanges; the New York Stock Exchange and the NASDAQ. The general strategies measured for adding
these stocks to the index are market value, industry group classification, capitalization, trading activity, fundamental
analysis, and emerging industries. On the other hand, the general guidelines for removing stocks to the index are mergers
& acquisitions, bankruptcies, restructuring, and lack of representation.
The S&P 500 index is calculated using market-value weighted or base-weighted aggregate methodology. The Index is
generally referred to as a price return index. In general, the rate of return of the S&P 500 Index equals to the rate of return
of a portfolio that holds all 500 stocks that are part of the Index in the proportion to their market values. The S&P 500
index is a price index and does not reflect any cash dividends the formula to calculate the
The formula to calculate the S&P 500 is;
∑
i Pi ∗ Qi
Index Level =
Div isor
where, the index level is the index value of that day. Pi are the ending prices for stocks on the day? Qi is the number of
outstanding shares or freely floating shares on the day.
6 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067

Fig. 2. Time series of S&P 500 index.

In a value-weight index, the importance of individual stocks in the sample depends on the market value of the stock.
Moreover, the prices movements of an index component with higher market capitalizations have a greater effect on the
index than companies with smaller market caps. The S&P 500 index calculations take in consideration corporate actions
such as stock splits, share issuance, stock dividends and restructuring events such as mergers or spinoffs. In addition,
the divisor needs to be adjusted because of corporate financial actions or when a company is dropped and replaced by
another company with a different market capitalization.

7.3. The volatility index (VIX index)

The VIX is an index used to measures the implied volatility of Out of the Money (OTM) put- and call options on the
SP500. It often referred to as the fear-index since the index reaches higher values in times of economic uncertainty. In
1993, the C B O E introduced it and its purpose was to measure the expectation of 30-days volatility implied by at-the-
money SP100 Index option prices (Chicago Board Options) Exchange Technical Notes [68]. For the volatility of the US stock
market VIX has become a standard and has an inverse relationship with the stock market. When the market is performing
well VIX is decreasing and when the market is performing bad VIX increases [69].
The (VIX) CBOE Implied Volatility Index was introduced by Robert E. Whaley in 1993 and was initially designed to
measure the market’s expectation of 30-day volatility implied by the at-the-money S&P 100 Index (OEX) option prices
(see Fig. 3).
The only significant difference from the previous VIX Index that was based on the S&P 100 market index is that the
revised VIX measures the volatility and not the price. Volatility is a crucially important variable when pricing derivative
securities, and a good forecast of the volatility of asset prices over the investment holding period is essential for assessing
investment risk [70]. VIX is an indicator that reflects the price of portfolio insurance [71] and determines how much
people are willing to pay for a stock, which essentially is measuring the future state of the economy [72]. According to
the CBOE VIX white paper (2009), VIX is a volatility index comprised of options rather than stocks, with the price of each
option reflecting the market’s expectation of future volatility. The VIX calculation could be divided in 3 steps; The first
step is selecting options to be used in the VIX equation by calculating the current "forward index level (F)" based on
the options strike price at which the difference between the average of the bid and ask spreads for the put and the call
options is the smallest. The second step is including the selected options in the VIX calculation:
]2
2 ∑ ∆ Ki
[
1 F
σ =
2
e Q (Ki ) −
RT
−1
T Ki2 T KO
i

where, ‘‘i’’ is the strike price. Ki represents the ‘‘ith" strike price from the forward index level (F), and "Ki " is strike price
of ith out-of-the-money option; a call if Ki > KO and a put if Ki < K0 , both put and call if Ki = K0 . Q (Ki ) is the midpoint of
the bid–ask spread for each option with strike Ki . K0 is the first strike below the forward index level (F). T is the time until
expiration as a proportion of the number of minutes in a year. R is risk-free of maturity T. Third, by taking the square
 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067 7

Fig. 3. Time series of VIX index.

root of the 30-day weighted average variance (σ 2 ) and multiplying it by 100 the VIX Index is obtained and ∆Ki denotes
the interval between strike prices, defined as
Ki+1 − Ki
∆ Ki =
2
The last term in equation represents the adjustment term via the put–call parity to convert this in-the-money call into
an out-of-money put.
The calculation involves all available call options at strikes greater than F and all put options at strikes lower than F.
The bids of these options must be strictly positive to be included. When at the boundary of the available options, the
definition for the interval ∆K modifies as follows: ∆K for the lowest strike is the difference between the lowest strike
and the next higher strike. Likewise, ∆K for the highest strike is the difference between the highest strike and the next
lower strike. To determine the forward index level F, CBOE chooses the pair of put and call options whose prices are the
closest to each other. Then, the forward price is derived via the put–call parity relation. The CBOE uses equation (1) to
calculate σ 2 at two of the shortest maturities of the available options, T1 and T2. Then, the CBOE linearly interpolates
between the two σ 2 to obtain a σ 2 at 30-day maturity. The VIX represents the annualized percentage of this 30-day σ ,
√
365 NT2 − 30 30 − NT1
VIX = 100 T1 σ12 + T2 σ22
30 NT2 − NT1 NT2 − NT1
where NT1 and NT2 denote the number of actual days to expirations for the two maturities. When the shortest maturity falls
within eight days, the CBOE switches to another maturity to avoid microstructure effects at very short option maturities

7.4. Time series of two index

VIX index is measured as the weighted 30 days implied standard deviation of annual changes in Standard & Poor’s 500.
For example, if the value of VIX is 20, then S&P500 is expected to increase or decrease by 20% over the next year [73].
The chart in Fig. 4 displays every day closing prices for the SP500 and VIX Indexes from the last five years i.e. from
2013 to 2017. The upper blue line represents the VIX index while the below yellow line represents SPX 500. Also, this
chart is the typical example of the relatively inverse relationship between two financial markets i.e. VIX and SP500 on
daily basis.
Therefore, our observation is that there is a negative correlation between stock return and volatility. So, when any
finance theory assumes that the stock return and volatility have a positive relationship and they are in the perfect market
it means that probably the market reaction is opposite of this assumption. Also, we suggest in assessing the degree of
market disorder is become particularly important to study the relationship of the market. Particularly this phenomenon
of observing markets are important since the October 1987 worst stock market crash i.e. great depression. Since then
documenting the level of market anxiety would provide useful benchmark information in assessing the degree of market
turbulence experienced.
8 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067

Fig. 4. Inverse relationship of VIX & SP500.

Source: https://www.bloomberg.com/quote/
SPX.

8. Points to ponder in review model ‘‘logic vs. perception’’

In pricing of any underlying security, volatility observation is very important such as derivatives whose trading volume
is magnified over the last few years. Since 1987 crash documenting the market anxiety become important and the option
pricing theory of Black–Scholes is one of the most significant concepts in modern finance. Whose objective is to derive
the arbitrage-free price of a given option which originates the price of an option in a frictionless market using a hedge
portfolio? [18,19]. The central assumption of BS theory is that volatility is constant which is not possible in real option
market, therefore, this point always attracts researchers to relax this constant volatility assumption. And many researchers
who relax this constant volatility assumption are [74–77]. However, all these studies exposed an empirical paradox that
all options did not yield the same volatility on the same underlying with the same expiration. And this dynamic volatility
is known as implied volatility With respect to strike prices and time to expiration there are always persistent patterns in
implied volatilities, and the combined effect of both of them is known as ‘ volatility skew or smirk’, however this smile
always remain a puzzling phenomenon [78].
In the meantime, when the BS formula having constant volatility assumption was facing criticism, the stock return
assumption also become the victim, which is that the return of underlying stock is normally distributed. It was pointed
out that the trading take place always on time and the stock have a continuous sample path [79]. It is not possible because
continuous trading is impossible, and it may have intervals in trading stock. Therefore, the arbitrage-free price has some
risk and return involved but this risk is bounded and limited when it reaches the level of continuous trading limit and at
that point, the risk goes to zero.
Changes in the stock prices has been taken into two directions. One aspect is ‘‘Normal’’ fluctuations [80]. Another,
‘‘abnormal’’ vibrations in price are due to the arrival of the important new information about the stock that has more than
a marginal effect on price. Usually, such information will be specific to the firm or possibly its industry. It is reasonable
to expect that there will be ‘‘active’’ times in the stock when such information arrives and ‘‘silent’’ times although the
‘‘active’’ and ‘‘silent’’ times are random. By its very nature, important information arrives only at discrete points in time.
This component is modeled by a ‘‘jump’’ process reflecting the non-marginal impact of the information [81–83]. And to
be consistent with the efficient market hypothesis and study the stock price dynamic in EMH perspective [80,84]. Thus,
this may cause implied volatility smile to appear [58].
Over the last two decades, the volatility smile received much attention by academics and practitioners because of the
appearance of the 1987 crash. The most celebrated stochastic volatility model, which set up the starting point of skewness
and kurtosis effects. This computational parameter permits to analysis and calculate options efficiently. This parameter
is also related to the correlation among the asset’s noise and the noise of the volatility process: in fact, this correlation
is responsible for the volatility smirk or smile (Skewness & Kurtosis affects), basically that smile is the slope of volatility
surface [78].
Even though financial models have become more sophisticated with time, many frequently used models are often
moderately complicated to calibrate and to use in pricing or forecasting. In this section, we concluded that there are few
 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067 9

points to ponder in review model and what is the logic of assuming them differently in theory and what the perception
is. Now there is need to see these parameters among different markets and compare the worth of change in these
assumptions.

9. Comparable worth

The fact that the VIX Index is still known as the ‘‘investor fear gauge’’ why is so because for investors it a mirror image
of market trends. As the market expected volatility increase investor demand higher rates of return on underlying so the
stock price falls and the vice versa both concepts are called leverage effect. This effect demonstrates the proportional
relationship of rates of SP500 Index with the rate of change in VIX and this relation is more complex.
Earlier we claimed and documented the negative correlation of stock return and volatility shown in Fig. 4 Hence,
we now observe the type of relationship by comparing both stock index markets and we observed the promotional
relationship which means that as the VIX rates change or get higher the stock market falls both have an indirect
relationship [22].
In 1970, after the collapse of Bretton Wood Systems, investor assumed that it is a shift from the fulcrum of power
and profit. In actual, it is an alteration in perspective that investors should shift from the circulation of capital towards
the circulation of capital, indicating that investors really want to hedge the risk which was seen upon as an externality
of the market [23,85]. Primarily research studies were focused on the issue whether the derivatives trading increases or
decrease the volatility in the underlying assets price [86].
In fact volatility risk and the unrealistic normal distribution assumption which creates unavoidable components of
market frictions. Market frictions create risks and prevent the market from completion [87]. Although researchers are
still engaged in trying to explain the proportional relationship of markets, and this has not slowed down its usage among
practitioners [88].
From the above discussion, we conclude that while investigating the behavior of index options market over the time
it is important to see the relation of return volatility and if the past years show the negative correlation than why do
researcher assume a positive relationship between the two variables. At certain points in financial theory, we should
highlight the problems meaning that when in future working on any other theory we should keep these points in mind,
through that we can easily avoid criticism.

10. Conclusion

Affirmative action is providing opportunities and favors for investors and financial intuitions who suffer from past
perception [42,89]. Here ‘by perception’ we mean that the previous financial model was under few retractions &
limitations and most of them assume that market is perfect which in actual is not. This may question the validity of
previous models same is the case with option pricing theory when its assumptions were criticized in financial markets.
Therefore, there is a need to change the idea or assumptions behind options pricing model to develop a new perception.
Option pricing is really a complex task and if anything goes wrong in options these days, investors face consequences.
Hence, they start learning and understanding the new dynamic behavior of markets. And for developing new perception
they use previous already develop a perception of the theory that how previously investors perceive the theory and now
what needs to be changed in theory assumptions. Options involve risk and are not suitable for all investors.
Combining the provision of knowledge from all the above literature we concluded that considering these points while
making make theory assumption is important. And our point of view that if history shows negative correlation than why
do ignore it why not consider the more realistic assumption to get more accuracy in theory. One last thing to consider
here is that by applying limitations we cannot get robustness in results and in financial world there is always a gap left
in theories for future research because of these limitations, and to get superior results we need to develop more realistic
assumptions while making theories.
Research of HFT at the connection of financialization and the information technology might support regulatory
authorities and market operators in improving market investigation and help to detect fraudulent activities. Besides,
distinguishing two market tiers is very challenging given many information sources and the enormous number of trades
occurring not least because of high-frequency traders. Therefore, computerized market observation tools require a wide-
ranging classification of financial market operations as a basis for a suitable relationship. Based on an HFT analysis of two
markets, a review of the latest trading methods regulation and academic studies, we highlight the market behavior of
financial market while using HFT, also reveals how these techniques differ along several dimensions.

Acknowledgments

It is not supported by any fund or any funding agency.

Declaration of competing interest

This work has no conflict of interest.

10 K. Shafi, N. Latif, S.A. Shad et al. / Physica A 527 (2019) 121067

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