Stock Illiquidity and Option Returns

Abstract

We provide evidence of a strong effect of the underlying stock’s illiquidity on option returns. By conditioning on end user demand, we find that the corresponding illiquidity premiums are negative and decrease in stock illiquidity if there is net buying pressure, while premiums are positive and tend to increase otherwise. Our results cannot be explained by common risk factors and cross-sectional differences in stock volatility or option spreads and are robust to different illiquidity measures and data periods. We explain the observed pattern through an intermediary hedging cost channel. The magnitudes of our illiquidity premiums are in line with reasonable transaction cost assumptions.

Keywords: Illiquidity, equity options, option returns, hedging costs

JEL Classification: G12, G13