How Underlying Liquidity Affects Option Bid-Ask Spreads

Summary

The document explains why options on an underlying with a wide bid-ask spread may also have wider spreads. One mechanism concerns options traded without delta hedging: a market maker who takes the other side may need to hedge by trading the underlying and incur its spread. That hedging cost can be reflected in the option quote.

A second mechanism follows from replication. An option’s value is linked to the cost of maintaining a hedge, and a delta hedge may need to be rebalanced over time. If each rebalance involves crossing a wide underlying spread, the accumulated trading costs can raise the cost of making a market in the option. The explanation is qualitative and does not quantify how large the effect will be. Actual option spreads can also depend on other market conditions, so the document establishes a cost channel rather than a fixed relationship between the two spreads.

Key ideas

• Wide underlying spreads can increase the cost of hedging an option trade.
• Market makers may pass the cost of crossing the underlying spread into option quotes.
• Delta hedges may require repeated rebalancing, adding transaction costs over time.
• Replication costs provide another channel connecting underlying liquidity to option spreads.
• The document describes a qualitative relationship without estimating its size.

Tags

# Are bid-ask spreads in options related to bid-ask spreads in their underlying?


# Are bid-ask spreads in options related to bid-ask spreads in their underlying?












If an underlying has a large bid-ask spread, does it mean that its options will have large bid-ask spreads too? Is there any relation between the bid-ask spreads of options and the bid-ask spreads of their underlying? If so, how and why?

## Answer by river_rat (score 2)

https://quant.stackexchange.com/a/58409

There is a relationship and it comes about two seperate ways. A live price of an option (so one traded without delta) will be wider in an illiquid market then a liquid one as the market maker would have to buy the delta hedge and cross that wide underlying spread. That is the easy case to see, however remember that an options value is in some sense determined by the cost of replication. So an underlying with a wide spread would be more costly to delta hedge as that spread would have to be crossed everytime the portfolio required rebalancing and thus would also increase the spread of options with delta.

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