Option Bid-Ask Spread and Scalping Risk: Evidence from a Covered Warrants Market

Journal of Futures Markets, Vol. 26, No. 9, 843-867

Posted: 30 Nov 2005 Last revised: 6 Sep 2010

See all articles by Giovanni Petrella

Giovanni Petrella

Università Cattolica del Sacro Cuore

Date Written: July 1, 2005

Abstract

This paper develops and empirically tests a simple market microstructure model to capture the main determinants of option bid-ask spread. The model is based on option market making costs (initial hedging, rebalancing, and order processing costs), and incorporates a reservation bid-ask spread that option market makers apply to protect themselves from scalpers. The model is tested on a sample of covered warrants, which are optionlike securities issued by banks, traded on the Italian Stock Exchange. The empirical analysis validates the model. The initial cost of setting up a delta neutral portfolio has been found to be an important determinant of option bid-ask spread, as well as rebalancing costs to keep the portfolio delta neutral. This result provides evidence of a further link between options and underlying assets: the spread of the option is positively related to the spread of its underlying asset. Empirical evidence also indicates that the reservation bid-ask spread, computed as the product of option delta and underlying asset tick, plays a very important role in explaining the bid-ask spread of options.

Keywords: covered warrants, scalpers, bid-ask spread

JEL Classification: G10, G20, G24

Suggested Citation

Petrella, Giovanni, Option Bid-Ask Spread and Scalping Risk: Evidence from a Covered Warrants Market (July 1, 2005). Journal of Futures Markets, Vol. 26, No. 9, 843-867. Available at SSRN: https://ssrn.com/abstract=855165

Giovanni Petrella (Contact Author)

Università Cattolica del Sacro Cuore ( email )

Largo Gemelli 1
Milano, 20123
Italy
+39 02 72343007 (Phone)

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