Option bid-ask spread and scalping risk: Evidence from a covered warrants market

Abstract

This study develops and empirically tests a simple market microstructure model to capture the main determinants of option bid-ask spread. The model is based on option market making costs (initial hedging, rebalancing, and order processing costs), and incorporates a reservation bid-ask spread that option market makers apply to protect themselves from scalpers. The model is tested on a sample of covered warrants, which are optionlike securities issued by banks, traded on the Italian Stock Exchange. The empirical analysis validates the model. The initial cost of setting up a delta neutral portfolio has been found to be an important I wish to thank an anonymous reviewer,

Market pricing of executive stock options and implied risk preferences

“…4). Also, they are shown to increase option bid-ask spreads by Jameson and Wilhelm (1992) and Petrella (2006).…”

“…Empirical studies take it as a measure of hedging costs. For example, Jameson and Wilhelm (1992) and Petrella (2006) show that the spread is largely explained by transaction costs and stochastic volatility risk. Our data does not include the spread, and even if it did, two reliability issues would arise.…”

Empirical test of the efficiency of the UK covered warrants market: Stochastic dominance and likelihood ratio test approach

“…They find that investors may perceive warrants as another type of instrument and that the warrants are over-priced over the first five trading days. Using 64 Italian covered warrants between 2000 and 2001 to examine the bid-ask spread of covered warrants, Petrella (2006) documents that the reservation spread plays an important role in determining the warrant spreads. Bartram and Fehle (2007) use data from EuRex (options) and EuWax (warrants) in Germany in 2000 to examine the degree of the bid-ask spread between warrants and options.…”

“…Recent studies highlight the difference between option-like covered warrants and the corresponding trading options (Aitken and Segara, 2005;Petrella, 2006). Researchers have also indicated that the introduction of covered warrants provides an alternative investment choice for market participants (Horst and Veld, 2008).…”

Does the Liquidity of Underlying Stocks Affect the Liquidity of Derivatives? Evidence from a Natural Experiment *

“…Jameson and Wilhelm (1992) empirically show that the inability to rebalance continuously explains the variations of bid-ask spreads quoted across options with different maturities and strike prices. Kaul et al (2004), Petrella (2006), Engle and Neri (2010), and Wu et al (2014) decompose the hedging costs into two components, the initial hedging costs and the rebalancing costs, and examine the role of each component in explaining the bid-ask spread of options. Wu et al (2014) decompose the rebalancing costs further into those due to inventory changes and those due to delta changes and find that the former is far more important than the latter in determining the option spreads.…”