An Empirical Analysis of the Relation between Option Market Liquidity and Stock Market Activity

42 Pages Posted: 28 May 2004

See all articles by Iskra Kalodera

Iskra Kalodera

University of Frankfurt

Christian Schlag

Goethe University Frankfurt; Leibniz Institute for Financial Research SAFE

Date Written: January 2004

Abstract

We empirically investigate the relation between daily activity in the underlying stock and option liquidity for firms included in the German DAX index and with options traded on the electronic exchange EUREX. By means of regression analyses we identify the major determinants of transaction-based and order-based option liquidity. We find that the transaction volume of the underlying stock is indeed a major determinant of transaction-based liquidity in the options market, whereas contrary to standard intuition, return volatility does not consistently exhibit a significant impact. On the other hand short-term measures of uncertainty, represented by the positive and negative parts of stock returns and their lagged values, are important explanatory factors. Order-based liquidity seems to be harder to model than transaction-based liquidity. The negative return part is a common factor influencing both spread and depth variables, while volatility overall significantly increases option market depth. As an important contribution to the empirical literature on option market liquidity, we provide separate regressions for buyer and seller initiated transactions. It becomes clear that especially the relation between stock returns and transaction-based liquidity is asymmetric with respect to option purchases and sales. Call purchases increase with positive returns and decrease on days with negative returns, while put purchases behave exactly the opposite way. However, both call and put sales increase on days with large positive or negative returns.

Keywords: Liquidity, market activity, options markets

JEL Classification: G12, G13

Suggested Citation

Kalodera, Iskra and Schlag, Christian, An Empirical Analysis of the Relation between Option Market Liquidity and Stock Market Activity (January 2004). Available at SSRN: https://ssrn.com/abstract=493502 or http://dx.doi.org/10.2139/ssrn.493502

Iskra Kalodera (Contact Author)

University of Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Christian Schlag

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, Hessen 60323
Germany

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany