Why Option Bid-Ask Spreads Do Not Directly Measure Risk Aversion

Summary

The note asks whether option bid-ask spreads for a given tenor can reveal risk aversion and help convert a risk-neutral density into a real-world density. The responses distinguish transaction costs and quoted market conditions from investors’ or market makers’ underlying risk preferences. A spread reflects the prices at which trades can occur and may be shaped by liquidity and trading venue; it is not, by itself, a direct measure of risk aversion.

One response also observes that current option trades may involve secondary sellers or occur away from market makers, making it difficult to infer an original market maker’s risk exposure from observed spreads. It mentions theoretical discussion of the topic but offers no implementable estimation procedure. The note therefore does not establish a method for transforming a risk-neutral density into a physical density; additional assumptions and data would be needed to identify risk preferences.

Key ideas

• An option bid-ask spread primarily reflects transaction costs and market conditions.
• A spread alone does not identify market makers’ or investors’ risk aversion.
• Secondary trading and off-exchange venues can obscure the source of quoted risk-bearing capacity.
• The note provides no practical procedure for converting a risk-neutral density into a real-world density.

Tags

# Estimating risk aversion from option bid-ask spreads


# Estimating risk aversion from option bid-ask spreads












Is it possible to use bid-ask spreads on contracts from a specific tenor to estimate risk aversion and use it to transform risk-neutral density into real-world density?

## Answer by Con Fluentsy (score 1)

https://quant.stackexchange.com/a/55271

Bid Ask spreads should reflect the willingness of parties to exchange at a certain price, where market makers are the sellers it represents the risks they are prepared to take in order to make the the market, but as most trades now are through secondary sellers, not market makers or in dark pools, it would be impossible to estimate the initial risk of a market maker, I do remember option writer Sheldon Natenberg discussed the topic, I can not recall the source, he is author of the timeless classic which put volatility on the map, Option Pricing and Volatility, I have seen a few other things but they are not really practically implementable, only of theoretical interest so I did not carefully collate and annotate, sorry.

## Answer by Ezy (score 0)

https://quant.stackexchange.com/a/54504

You are mixing 2 different concepts. bid-offer spread is reflective of transaction costs, not of risk aversion of market-makers.

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