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Trading activity and bid-ask spreads of individual equity options

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  • Wei, Jason
  • Zheng, Jinguo
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    Abstract

    We empirically examine the impact of trading activities on the liquidity of individual equity options measured by the proportional bid-ask spread. There are three main findings. First, the option return volatility, defined as the option price elasticity times the stock return volatility, has a much higher power in explaining the spread variations than the commonly considered liquidity determinants such as the stock return volatility and option trading volume. Second, after controlling for all the liquidity determinants, we find a maturity-substitution effect due to expiration cycles. When medium-term options (60-90Â days maturity) are not available, traders use short-term options as substitutes whose higher volume leads to a smaller bid-ask spread or better liquidity. Third, we also find a moneyness-substitution effect induced by the stock return volatility. When the stock return volatility goes up, trading shifts from in-the-money options to out-of-the-money options, causing the latter's spread to narrow.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 34 (2010)
    Issue (Month): 12 (December)
    Pages: 2897-2916

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    Handle: RePEc:eee:jbfina:v:34:y:2010:i:12:p:2897-2916

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    Web page: http://www.elsevier.com/locate/jbf

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    Keywords: Trading activity Bid-ask spread Option expiration cycles Liquidity Liquidity determinants Volume Open interest;

    References

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    Cited by:
    1. Narayan, Paresh Kumar & Mishra, Sagarika & Narayan, Seema, 2014. "Spread determinants and the day-of-the-week effect," The Quarterly Review of Economics and Finance, Elsevier, Elsevier, vol. 54(1), pages 51-60.
    2. Mugwagwa, Tafadzwa & Ramiah, Vikash & Naughton, Tony & Moosa, Imad, 2012. "The efficiency of the buy-write strategy: Evidence from Australia," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 22(2), pages 305-328.
    3. Wu, Wei-Shao & Liu, Yu-Jane & Lee, Yi-Tsung & Fok, Robert C.W., 2014. "Hedging costs, liquidity, and inventory management: The evidence from option market makers," Journal of Financial Markets, Elsevier, Elsevier, vol. 18(C), pages 25-48.
    4. Khoury, Nabil & Perrakis, Stylianos & Savor, Marko, 2011. "Competition, interlisting and market structure in options trading," Journal of Banking & Finance, Elsevier, Elsevier, vol. 35(1), pages 104-117, January.

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