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Stock Illiquidity, option prices, and option returns

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  • Kanne, Stefan
  • Korn, Olaf
  • Uhrig-Homburg, Marliese

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 net long in options on some underlyings and net short in options on other underlyings. Our empirical findings are robust with respect to the chosen illiquidity measure, the measure of option expensiveness, and the return period.

Suggested Citation

  • Kanne, Stefan & Korn, Olaf & Uhrig-Homburg, Marliese, 2016. "Stock Illiquidity, option prices, and option returns," CFR Working Papers 16-08, University of Cologne, Centre for Financial Research (CFR).
    • Handle: RePEc:zbw:cfrwps:1608
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    File URL: https://www.econstor.eu/bitstream/10419/146777/1/869413082.pdf
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    References listed on IDEAS

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    Cited by:

    1. Ruan, Xinfeng, 2020. "Volatility-of-volatility and the cross-section of option returns," Journal of Financial Markets, Elsevier, vol. 48(C).
    2. Jaspersen, Stefan, 2021. "Mutual Fund Bets on Market Power," CFR Working Papers 16-07, University of Cologne, Centre for Financial Research (CFR), revised 2021.
    3. Olaf Korn & Paolo Krischak & Erik Theissen, 2019. "Illiquidity transmission from spot to futures markets," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 39(10), pages 1228-1249, October.
    4. Ruan, Xinfeng & Zhang, Jin E., 2018. "Risk-neutral moments in the crude oil market," Energy Economics, Elsevier, vol. 72(C), pages 583-600.
    5. Korn, Olaf & Kuntz, Laura-Chloé, 2017. "Low-beta strategies," CFR Working Papers 15-17 [rev.], University of Cologne, Centre for Financial Research (CFR), revised 2017.

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    More about this item

    Keywords

    illiquidity; equity options; option returns; option strategies;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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    This paper has been announced in the following NEP Reports:

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