Option Happiness and Liquidity: Is the Dynamics of the Volatility Smirk Affected by Relative Option Liquidity?

Abstract

This study investigates the dynamic relationship between option happiness (the steepness of the volatility smirk) and relative index option liquidity. We find that, on a daily basis, option happiness is significantly dependent on the relative liquidity between option series with different moneyness. In particular, the larger the difference in liquidity between an out-of-the-money option and a concurrent at-the-money call option, the larger the option happiness. This relationship is robust to various relative option liquidity measures based on bid-ask spreads, trading volumes and option price impacts. The results also show a significant maturity effect in option happiness, consistent with the notion that options are “dying smiling”.

Keywords: implied volatility, volatility smirk, option happiness, relative option liquidity

JEL Classification: G13