Price impact versus bid–ask spreads in the index option market

Andreas Kaeck; Vincent van Kervel; Norman J. Seeger

doi:10.1016/j.finmar.2021.100675

Price impact versus bid–ask spreads in the index option market

Andreas Kaeck, Vincent van Kervel, Norman J. Seeger^*

^*Corresponding author for this work

Research output: Contribution to Journal › Article › Academic › peer-review

Abstract

We investigate the puzzle of why bid–ask spreads of options are so large by focussing on the price impact component of the spread. We propose a structural vector autoregressive model for trades in the option market to analyze whether they move the underlying price and/or the underlying's volatility. Our model captures cross-option strategies by pooling order flows across contracts after a decomposition into exposure to the underlying asset and its volatility. While our estimates confirm that S&P500 option trades indeed significantly move the underlying and the volatility, the economic magnitudes are very small. Hence, large bid–ask spreads of options remain a puzzle.

Original language	English
Article number	100675
Pages (from-to)	1-22
Number of pages	22
Journal	Journal of Financial Markets
Volume	59
Issue number	Part A
Early online date	24 Sept 2021
DOIs	https://doi.org/10.1016/j.finmar.2021.100675
Publication status	Published - Jun 2022

Bibliographical note

Funding Information:
We thank Dmitriy Muravyev, Ioanid Rosu, and Bart Zhou Yueshen for extremely useful comments. We are also thankful for the suggestions by seminar participants at the 2018 Lancaster financial econometrics conference. van Kervel gratefully acknowledges the financial support of the Fondecyt Iniciación, Chile (project 11150485 ).

Publisher Copyright:
© 2021 The Authors

Keywords

Informed trading
Liquidity
Options
Price impact

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title = "Price impact versus bid–ask spreads in the index option market",

abstract = "We investigate the puzzle of why bid–ask spreads of options are so large by focussing on the price impact component of the spread. We propose a structural vector autoregressive model for trades in the option market to analyze whether they move the underlying price and/or the underlying's volatility. Our model captures cross-option strategies by pooling order flows across contracts after a decomposition into exposure to the underlying asset and its volatility. While our estimates confirm that S&P500 option trades indeed significantly move the underlying and the volatility, the economic magnitudes are very small. Hence, large bid–ask spreads of options remain a puzzle.",

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AU - van Kervel, Vincent

AU - Seeger, Norman J.

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N2 - We investigate the puzzle of why bid–ask spreads of options are so large by focussing on the price impact component of the spread. We propose a structural vector autoregressive model for trades in the option market to analyze whether they move the underlying price and/or the underlying's volatility. Our model captures cross-option strategies by pooling order flows across contracts after a decomposition into exposure to the underlying asset and its volatility. While our estimates confirm that S&P500 option trades indeed significantly move the underlying and the volatility, the economic magnitudes are very small. Hence, large bid–ask spreads of options remain a puzzle.

AB - We investigate the puzzle of why bid–ask spreads of options are so large by focussing on the price impact component of the spread. We propose a structural vector autoregressive model for trades in the option market to analyze whether they move the underlying price and/or the underlying's volatility. Our model captures cross-option strategies by pooling order flows across contracts after a decomposition into exposure to the underlying asset and its volatility. While our estimates confirm that S&P500 option trades indeed significantly move the underlying and the volatility, the economic magnitudes are very small. Hence, large bid–ask spreads of options remain a puzzle.

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Price impact versus bid–ask spreads in the index option market

Abstract

Bibliographical note

Keywords

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