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Stock Illiquidity, Option Prices, and Option Returns

40 Pages Posted: 7 Dec 2015 Last revised: 3 Jun 2016

Stefan Kanne

Karlsruhe Institute of Technology (KIT) - Institute for Finance

Olaf Korn

Georg-August-Universität Göttingen

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance

Date Written: June 1, 2016

Abstract

We provide evidence of a strong effect of the underlying stock’s illiquidity on option prices by showing that the average absolute difference between historical and implied volatility increases with stock illiquidity. This pattern translates into significant excess returns of option trading strategies that are not explained by common risk factors. Simulation results show, however, that our results can be explained by the hedging costs of market makers who are sometimes net long and sometimes net short in options. Our empirical findings are robust with respect to the chosen illiquidity measure, the measure of option expensiveness, and the return period.

Keywords: Illiquidity, equity options, option returns, option strategies

JEL Classification: G12, G13

Suggested Citation

Kanne, Stefan and Korn , Olaf and Uhrig-Homburg, Marliese, Stock Illiquidity, Option Prices, and Option Returns (June 1, 2016). Available at SSRN: https://ssrn.com/abstract=2699529

Stefan Kanne (Contact Author)

Karlsruhe Institute of Technology (KIT) - Institute for Finance ( email )

D-76128 Karlsruhe
Karlsruhe
Germany

Olaf Korn

Georg-August-Universität Göttingen ( email )

Platz der Göttinger Sieben 3
D-37073 Göttingen
Germany

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance ( email )

P.O. Box 6980
D-76049 Karlsruhe, DE
Germany
+49 721 6084 8183 (Phone)
+49 721 6084 8190 (Fax)

HOME PAGE: http://derivate.fbv.kit.edu/english/index.php

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