Illiquidity Premia in the Equity Options Market

Abstract

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