Illiquidity Premia in the Equity Options Market
Review of Financial Studies
72 Pages Posted: 15 Mar 2011 Last revised: 22 Sep 2017
Date Written: September 21, 2017
Standard option valuation models leave no room for option illiquidity premia. Yet we find the risk-adjusted return spread for illiquid over liquid equity options is 3.4 percent per day for at-the-money calls and 2.5 percent for at-the-money puts. These premia are computed using option illiquidity measures constructed from intraday effective spreads for a large panel of US equities, and they are robust to different empirical implementations. Our findings are consistent with evidence that market makers in the equity options market hold large and risky net long positions on average. We show that the positive illiquidity premium compensates market makers for the risks and costs of these long positions.
Keywords: Illiquidity; equity options; cross-section; delta-hedged option returns
JEL Classification: G12
Suggested Citation: Suggested Citation