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.
Highlights
An important puzzle in the option market literature is why the trading costs are so large, as represented by bid–ask spreads
Option bid–ask spreads: We first show implicit trading costs in terms of option bid–ask spreads and compare these to estimated price impacts
We offer a novel framework to estimate the price impact of the aggregate option market
Summary
An important puzzle in the option market literature is why the trading costs are so large, as represented by bid–ask spreads. Gârleanu et al (2009) formalize this point in a model with risk-averse option market makers who charge (cross-option) price pressures, which in equilibrium are proportional to the unhedgeable component of the option inventory position These authors do not allow option order flows to move the level of the underlying or volatility, which is conceptually important in models of informed trading. Rourke (2014) uses a similar price impact VAR model with delta and vega flows estimated using order flows of a single option contract He uses the returns of a straddle, a portfolio with only vega exposure, to proxy for VIX returns, which makes it difficult to gauge the economic magnitude of the impact of volatility.
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