Does the market compensate buyers of illiquid options? In their March 2011 paper entitled “Illiquidity Premia in the Equity Options Market”, Peter Christoffersen, Ruslan Goyenko, Kris Jacobs and Mehdi Karoui investigate the impact of illiquidity of equity options and underlying stocks on option returns. They consider two option expiration horizons, short-term (20 to 70 days) and long-term (71 to 180 days), segmented by moneyness as in-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM). They compute option returns using end-of-day quoted bid-ask midpoints. They define stock illiquidity as the effective spread obtained from high-frequency intraday trade-and-quote data and option illiquidity with quoted end-of-day bid-ask spreads relative to midpoints. Using daily option closing bid and ask quotes for those S&P500 components that have traded options over the entire period of 1996 through 2007 (341 firms), filtered for reliability, along with comparable data for underlying stocks, they find that:
- Short-term contracts tend to be less liquid than long-term contracts, regardless of moneyness. For example, the average bid-ask spread relative to midpoint of short-term (long-term) OTM calls is 34% (23%).
- OTM options tend to be less liquid than ATM options, which in turn tend to be less liquid than ITM options.
- There is no obvious relationship between liquidity and volume in the options market, because market makers can hedge low-volume options with actively traded options in the same series with other strikes and expiration horizons.
- Option (and stock) illiquidity generally decreases over the sample period, with occasional large spikes at crises. Option illiquidity is substantially more volatile than stock illiquidity.
- Option illiquidity relates positively to future option returns across moneyness and expiration horizons. For example, an increase of two standard deviations in illiquidity of short-term OTM calls (puts) relates to an increase in next-day gross option return of 2.4% (1.6%). Average returns for option portfolios sorted on illiquidity increase systematically from the most liquid to the most illiquid decile.
- Stock illiquidity relates negatively to future option returns. For example, an increase of two standard deviations in illiquidity of a stock relates to a decrease in next-day associated short-term OTM call (put) gross option return of 0.87% (59%).
- While option-implied volatility tends to increase with stock illiquidity, implied volatility relates negatively to option illiquidity. Also, the implied volatility curve across levels of moneyness is steeper for more illiquid option contracts.
In summary, evidence suggests that low-cost traders may be able to extract an illiquidity premium from equity options, but perhaps more realistically indicates that the premium counterbalances trading friction for option buyers.
Cautions regarding findings include:
- The study presents gross, not net, returns. Given the relationship between trading friction and liquidity, incorporation of realistic trading frictions could substantially alter findings, perhaps even making the specified liquidity premium disappear. Trading frictions are far more important in options trading than stock trading because the frictions are large and expiration forces trading.
- The regression approach that relates two standard deviation increases in illiquidity to future option returns appears to be in-sample, and the standard deviation of illiquidity may not be stable over time. In other words, a trader operating in real time over the sample period probably would not know this relationship.
- As noted by a reader, because market makers and large traders are relatively more powerful in the options market than the equity market, bid-ask spreads used in the study to infer option returns and calculate option liquidity may exhibit unusual (artificial) behavior at the end of the trading day.
Frequently Asked Questions
What is option illiquidity and how is it different from stock illiquidity?
Option illiquidity is the cost and difficulty of trading an option, measured in the study as the quoted end-of-day bid-ask spread relative to the bid-ask midpoint. Stock illiquidity is measured differently, using the effective spread from high-frequency intraday trade-and-quote data. Option illiquidity is substantially more volatile than stock illiquidity, and in the study short-term OTM calls averaged a 34% relative spread.
Does option illiquidity predict higher future option returns?
Option illiquidity relates positively to future option returns across moneyness and expiration horizons in S&P 500 component options from 1996 through 2007. A two-standard-deviation increase in illiquidity of short-term OTM calls (puts) relates to a 2.4% (1.6%) higher next-day gross option return, and portfolios sorted on illiquidity show returns rising systematically from the most liquid to the most illiquid decile. The evidence suggests the premium may mainly offset trading friction for option buyers rather than offer an easy profit.
How is the illiquidity premium in equity options measured and tested?
The study computes option returns from end-of-day quoted bid-ask midpoints and measures option illiquidity as the quoted bid-ask spread relative to the midpoint. It uses daily option quotes for 341 S&P 500 components with traded options from 1996 through 2007, plus comparable underlying stock data. Contracts are split into short-term (20 to 70 days) and long-term (71 to 180 days) horizons and into ITM, ATM and OTM categories, and regressions relate illiquidity to next-day option returns.
Does stock illiquidity affect option returns the same way option illiquidity does?
No, stock illiquidity relates negatively to future option returns, the opposite of option illiquidity's positive relationship. A two-standard-deviation increase in stock illiquidity relates to a 0.87% decrease in next-day short-term OTM call gross returns. Option-implied volatility also tends to rise with stock illiquidity but falls with option illiquidity.
What are the limitations of using an option illiquidity premium as a trading strategy?
The reported returns are gross, not net, so realistic trading frictions, which are large in options and amplified by expiration, could substantially shrink or even eliminate the premium. The regression linking two-standard-deviation illiquidity increases to future returns appears to be in-sample, and the standard deviation of illiquidity may not be stable over time, so a real-time trader likely could not have known the relationship. End-of-day bid-ask spreads used to infer returns and liquidity may also behave unusually because market makers and large traders are powerful in options markets.