Option Bid–Ask Spread and Liquidity

Abstract

This article focuses on the search for a economically meaningful and easy to implement summary quantitative measure for option liquidity. The author shows that the relative spread measure (quoted dollar bid–ask spread relative to the midquote price) not only leads to liquidity ranking of options that is contrary to the popular view, but it is also biased against lower-priced options and hence can lead to erroneous conclusion about the liquidity risk premium of options. To gain economic insight in this regard, he uses a simple inventory hedging model of bid–ask spreads. He proposes two alternative summary measures of option liquidity: one using the implied dollar volatility of the asset to scale the dollar spread and the other expressing the bid, ask, and midquote option prices in terms of respective implied volatilities. Using a sample of more than two million end-of-day option quotes for 30 Dow Jones stocks and Goldman Sachs, the author finds that these very simple and intuitive measures seem to produce a liquidity ranking of options that is generally consistent with common knowledge about options liquidity.