Factors That Determine Bid-Ask Spreads in Option Quotes

Summary

The document asks how market makers choose bid-ask spreads for options quoted in implied volatility terms. It gives an example of a quote with a one-point gap between bid and ask volatility, and suggests that market volatility and the need to hedge inventory may affect the width.

It raises the possibility of quantitative methods for setting spreads, but supplies no model, market data, or answer describing actual market-making practice. As a result, it serves mainly as a framing of the problem: option spread setting may involve both changing market conditions and the costs or risks of managing a position. The example does not establish a general relationship between volatility and spread size, and the document leaves open how liquidity, competition, hedging costs, and inventory risk might be measured or combined.

Key ideas

• The document frames option bid-ask spreads in implied volatility terms.
• It asks how market makers determine spread width in practice.
• It proposes market volatility and the need to hedge inventory as possible influences.
• It provides no quantitative spread-setting method or empirical evidence.

Tags

# Spread in Option Quotes


# Spread in Option Quotes












Let's take a look at market-maker's option quote in vol terms: 8.5 / 9.5. In that example bid-ask spread equals 1.0 point of vol.

Can anybody clarifying how market-maker choose amount of spread in real life? Intuitively clear that it depends on volatility. The higher volatility entails higher bid-ask spread and vice versa. Besides this marker-maker must to hedge own position (if he bought/sold option). Likely it determines bid-ask spread amount too.

Are there any quantitative approaches to define bid-ask spread? How market-mnakers do it in real life?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.