Option Bid-Ask Spread and Liquidity

This paper focuses on the search for a summary quantitative measure for option liquidity that is economically meaningful and easy to implement. We show that the relative spread measure (quoted dollar bid-ask spread relative to the mid-quote price) not only leads to liquidity ranking of options that is contrary to the popular view, but it is also biased against lower priced options and hence can lead to erroneous conclusion about liquidity risk premium of options. To gain economic insight in this regard, we use a simple inventory hedging model of bid-ask spread.We propose two alternative summary measures of option liquidity, one using the option implied dollar volatility of the asset to scale the dollar spread and the other expressing the bid, ask and mid-quote option prices in terms of respective implied volatilities. Using a sample of more than two million end of day option quotes for thirty Dow Jones stocks and Goldman Sachs, we find that these very simple and intuitive measures seem to produce liquidity ranking of options that is generally consistent with common knowledge about options liquidity