Option Market Liquidity: Commonality and Other Characteristics

Abstract

This study examines the option market liquidity using Ivy DB's OptionMetrics data. We establish convincing evidence of commonality for various liquidity measures based on the bid-ask spread, volumes and price impact. The commonality remains strong even after controlling for the underlying stock market's liquidity and other liquidity determinants such as volatility. Smaller firms and firms with a higher volatility exhibit stronger commonalities in option liquidity. Aside from commonality, we also uncover several other important properties of the option market's liquidity. First, information asymmetry plays a much more dominant role than inventory risk as a fundamental driving force of liquidity. Changes in options' bid-ask spread and volume are found to be positively correlated, consistent with the notion that informed traders trade in the option market (Black, 1975; Easley, O'Hara and Srinivas, 1998; and Pan and Poteshman, 2006) and that market makers infer information from the volume and protect themselves by widening the spread in reaction to an increase in the trading volume (Easley and O'Hara, 1992; and Kim and Verrecchia, 1994). Second, the market-wide option liquidity is closely linked to the underlying stock market's movements. This is manifested in two aspects. For one, options' liquidity responds asymmetrically to upward and downward market movements. For instance, the proportional bid-ask spread of call options decreases in up markets and increases in down markets. For another, call and put options react to the same market movement to different extents, with calls reacting more in up markets and puts reacting more in down markets.

Keywords: Liquidity, Liquidity Commonality, Option Market Liquidity, and Stock Market Liquidity

JEL Classification: G10, G12, D82