Trading Activity and Bid-Ask Spreads of Individual Equity Options

56 Pages Posted: 15 Feb 2010

See all articles by Jinguo Zheng

Jinguo Zheng

Peking University - Guanghua School of Management

Jason Zhanshun Wei

University of Toronto - Rotman School of Management

Date Written: February 10, 2010

Abstract

We empirically examine the impact of trading activities on the liquidity of individual equity options measured by the proportional bid-ask spread. There are three main findings. First, the option return volatility, defined as the option price elasticity times the stock return volatility, has a much higher power in explaining the spread variations than the commonly considered liquidity determinants such as the stock return volatility and option trading volume. Second, after controlling for all the liquidity determinants, we find a maturity-substitution effect due to expiration cycles. When medium-term options (60-90 days maturity) are not available, traders use short-term options as substitutes whose higher volume leads to a smaller bid-ask spread or better liquidity. Third, we also find a moneyness-substitution effect induced by the stock return volatility. When the stock return volatility goes up, trading shifts from in-the-money options to out-of-the-money options, causing the latter's spread to narrow.

Keywords: Trading Activity, Bid-ask Spread, Option Expiration Cycles, Liquidity, Liquidity Determinants, Volume, Open Interest

JEL Classification: G10, G12, G14

Suggested Citation

Zheng, Jinguo and Wei, Jason Zhanshun, Trading Activity and Bid-Ask Spreads of Individual Equity Options (February 10, 2010). Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1553222 or http://dx.doi.org/10.2139/ssrn.1553222

Jinguo Zheng

Peking University - Guanghua School of Management ( email )

Peking University
Beijing, Beijing 100871
China

Jason Zhanshun Wei (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-978-3698 (Phone)
416-971-3048 (Fax)

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