Illiquidity Premia in the Equity Options Market

Abstract

Standard option valuation models leave no room for option illiquidity premia. Yet we find that the risk-adjusted return spread for illiquid over liquid equity call options is 22 bps per day for at-the-money calls and 42 bps overall. These illiquidity premiums are computed using state-of-the-art option illiquidity measures for a large panel of US equities, and are robust to different empirical implementations. Results for puts are not economically or statistically significant. These findings are consistent with evidence that market makers in the equity options market hold large and risky net long positions in calls but much smaller net positions in puts.