Commonality in equity options liquidity: evidence from European Markets

Abstract

This paper examines the commonality in liquidity for individual equity options trading at NYSE LIFFE. We use high-frequency data to construct a novel index of liquidity commonality and we find that it can explain a substantial proportion of the liquidity variation of individual options.The explanatory power of the common liquidity factor is more pronounced during periods of higher implied volatility at the market level. The common factor's impact on individual options' liquidity is found to depend on the options' idiosyncratic characteristics, while there is limited evidence of systematic liquidity spillover effects among the NYSE LIFFE exchanges.JEL Classifications: G12; G19

What do we know about individual equity options?

“…M. Cao and Wei () show evidence that asymmetric information is one of the main components of the bid–ask spread. Verousis et al () further show that volume and volatility are positively related to the bid–ask spreads of individual equity options, consistent with information asymmetry and hedging‐cost effects on option liquidity. Christoffersen et al () confirm the previous literature by showing that proxies for asymmetric information and hedging costs (and also stock illiquidity, inventory risk, and option‐order imbalances) are significant drivers of effective spreads.…”

Excess cash and equity option liquidity

“…Following Verousis, ap Gwilym, and Voukelatos (2016), we use the ratio of put to call traded volume to capture investor sentiment. A rise (fall) in the ratio means that more put options are bought relative to call…”

“…Finance researchers have spent considerable effort to explore the determinants of option market liquidity. In particular, the liquidity in option markets is affected by underlying stock liquidity (Cho & Engle, 1999; Muravyev & Pearson, 2020), inventory risk (Wu et al, 2014), information asymmetry (Cao & Wei, 2010), insider trading (Augustin et al, 2019; Biais & Hillion, 1994), and investor sentiment (Verousis, ap Gwilym, & Voukelatos, 2016).…”

Commonality in liquidity across options and stock futures markets

“…The dataset includes maturity date, strike price (for options), timestamped volume and price for asks, bids and trades. Our data screening follows the approaches documented in Cao and Wei (2010) and Verousis et al (2016).…”

“…Most studies of liquidity commonality focus on equity markets. Research on other asset classes remains limited (Pu, 2009;Cao and Wei, 2010;Marshall et al, 2013;Verousis et al, 2016). Another underdeveloped yet important research area is commonality in liquidity across different markets (Chordia et al, 2005;Pu, 2009;Mancini et al, 2013;Frino et al, 2014).…”