Corn Cobs and the Option Illiquidity Premia
A widely accepted proxy for measuring option liquidity is the effective spread, the difference between the NBBO (national best bid-offer) and the price at which the end-user transacts at. Due to the idiosyncratic risks derivatives carry, options are generally less liquid and have larger effective spreads than their equities counterparts. Christoffersen et al. (2018) demonstrate the prevalence of larger effective spreads on S&P 500 single name options from 2004-2012. Increased end-user costs as a result of larger effective spreads—and therefore illiquidity—are referred to as ‘option illiquidity premia.’ These permia exist as a means for compensating market makers for accepting the costs of high-frequency hedging, managing inventory, and accounting for asymmetric information and certain unhedgeable risks (Christoffersen et al. 2018; Garleanu et al. 2008).
However, illiquidity in options markets may not always imply illiquidity premia. Unlike with other asset classes, derivatives markets are zero net supply markets. By contrast, commodities like corn have positive net supply: the tangible good of corn is constantly being grown for our purchase and consumption. But options are not corn, and options transactions are offsetting, so that parties directly exchange profits and losses with one another (See Figure 1.1).