Stock Illiquidity, Option Prices, and Option Returns
40 Pages Posted: 7 Dec 2015 Last revised: 3 Jun 2016
Date Written: June 1, 2016
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: Suggested Citation