Limits to Market Making and the Skewness Risk Premium in Options Markets

Abstract

The finance literature has found it challenging to explain empirically observed option returns, most notably in the case of out-of-the-money (OTM) equity index puts. I propose liquidation risk in options markets, defined as the possibility of forced selling of speculative positions following a liquidity shock, as a major driver of the relative pricing of OTM put vs. call options (option-implied skewness) as well as their relative returns (skewness risk premium). Employing size and sign of speculative net long positions (OSP) in a panel of commodity futures options markets as a key proxy for liquidation risk, I find that both implied skewness as well as the skewness risk premium are positively correlated with OSP and that these effects are stronger when funding conditions deteriorate. I also provide direct evidence of the price effects during such liquidation events. Trading strategies designed to theoretically exploit the skewness premium yield up to 2.5 percent per month and load significantly on risk factors related to the ease of funding for financial intermediaries.

Keywords: commodity futures, option-implied skewness, limits to arbitrage, market making

JEL Classification: G13