Commonality in Liquidity: Evidence from the Option Market

40 Pages Posted: 21 May 2007 Last revised: 17 Feb 2010

See all articles by Melanie Cao

Melanie Cao

York University - Schulich School of Business

Jason Zhanshun Wei

University of Toronto - Rotman School of Management

Date Written: May 15, 2007

Abstract

This study examines the property of liquidity in the option market. Using Ivy DB's OptionMetrics data for the period of January 1, 1996 to December 31, 2004, we establish convincing evidence of commonality in options liquidity. The commonality remains strong even after controlling for the impact of the underlying stock market and other liquidity determinants. Other findings include: 1) the stock market exhibits a much stronger commonality than does the option market, 2) compared with the inventory risk, information asymmetry plays a more dominant role in influencing options liquidity and 3) the market-wide option liquidity depends on the underlying stock market's movements - for instance, the bid-ask spread of calls decreases (increases) when the overall market goes up (down), while that of puts takes the opposite pattern. The study also uncovers several interesting phenomena that warrant future research. One such phenomenon is the negative relationship between the percentage bid-ask spread and the volatility, contrary to the previous empirical evidence and what the information asymmetry theory predicts.

Keywords: Liquidity, Liquidity Commonality, Option Market Liquidity, and Stock Market Liquidity.

JEL Classification: G10,G12,D82

Suggested Citation

Cao, Melanie and Wei, Jason Zhanshun, Commonality in Liquidity: Evidence from the Option Market (May 15, 2007). Journal of Financial Markets, Vol. 13, No. 1, 2010. Available at SSRN: https://ssrn.com/abstract=987557

Melanie Cao

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100 ext. 33801 (Phone)

Jason Zhanshun Wei (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-978-3698 (Phone)
416-971-3048 (Fax)

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