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 determinant of option bid-ask spread, as well as rebalancing costs to keep the portfolio delta neutral. This result provides evidence of a further link between options and underlying assets: the spread of the option is positively related to the spread of its underlying asset. Empirical evidence also indicates that the reservation bid-ask spread, computed as the product of option delta and underlying asset tick, plays a very important role in explaining the bid-ask spread of options. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:843–867, 2006