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Option bid‐ask spread and scalping risk: Evidence from a covered warrants market

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  • Giovanni Petrella

Abstract

This study develops and empirically tests a simple market microstructure model to capture the main determinants of option bid‐ask spread. The model is based on option market making costs (initial hedging, rebalancing, and order processing costs), and incorporates a reservation bid‐ask spread that option market makers apply to protect themselves from scalpers. The model is tested on a sample of covered warrants, which are optionlike securities issued by banks, traded on the Italian Stock Exchange. The empirical analysis validates the model. The initial cost of setting up a delta neutral portfolio has been found to be an important determinant of option bid‐ask spread, as well as rebalancing costs to keep the portfolio delta neutral. This result provides evidence of a further link between options and underlying assets: the spread of the option is positively related to the spread of its underlying asset. Empirical evidence also indicates that the reservation bid‐ask spread, computed as the product of option delta and underlying asset tick, plays a very important role in explaining the bid‐ask spread of options. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:843–867, 2006

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  • Giovanni Petrella, 2006. "Option bid‐ask spread and scalping risk: Evidence from a covered warrants market," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 26(9), pages 843-867, September.
    • Handle: RePEc:wly:jfutmk:v:26:y:2006:i:9:p:843-867
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    Cited by:

    1. Bae, Kwangil & Lee, Soonhee, 2022. "Prices of derivative warrants considering their market characteristics and short-selling costs of underlying assets," Finance Research Letters, Elsevier, vol. 45(C).
    2. Schertler, Andrea, 2021. "Listing of classical options and the pricing of discount certificates," Journal of Banking & Finance, Elsevier, vol. 123(C).
    3. Li, Yubin & Zhao, Chen & Zhong, Zhaodong, 2019. "Price discrimination against retail Investors: Evidence from mini options," Journal of Banking & Finance, Elsevier, vol. 106(C), pages 50-64.
    4. Wong, W.-K. & Lean, H.H. & McAleer, M.J. & Tsai, F.-T., 2018. "Why did Warrant Markets Close in China but not Taiwan?," Econometric Institute Research Papers EI2018-22, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.
    5. Entrop, Oliver & Fischer, Georg, 2019. "Hedging costs and joint determinants of premiums and spreads in structured financial products," Passauer Diskussionspapiere, Betriebswirtschaftliche Reihe B-34-19, University of Passau, Faculty of Business and Economics.
    6. Giovanni Petrella & Reuben Segara, 2013. "The bid--ask spread of bank-issued options: a quantile regression analysis," Quantitative Finance, Taylor & Francis Journals, vol. 13(8), pages 1241-1255, July.
    7. Judith Glaser & Pascal Heider, 2012. "Arbitrage-free approximation of call price surfaces and input data risk," Quantitative Finance, Taylor & Francis Journals, vol. 12(1), pages 61-73, August.
    8. Baule, Rainer & Münchhalfen, Patrick & Shkel, David & Tallau, Christian, 2023. "Fair-washing in the market for structured retail products? Voluntary self-regulation versus government regulation," Journal of Banking & Finance, Elsevier, vol. 148(C).
    9. Dmitriy Muravyev & Neil D Pearson & Stijn Van Nieuwerburgh, 2020. "Options Trading Costs Are Lower than You Think," The Review of Financial Studies, Society for Financial Studies, vol. 33(11), pages 4973-5014.
    10. Chan, Chia-Ying & de Peretti, Christian & Qiao, Zhuo & Wong, Wing-Keung, 2012. "Empirical test of the efficiency of the UK covered warrants market: Stochastic dominance and likelihood ratio test approach," Journal of Empirical Finance, Elsevier, vol. 19(1), pages 162-174.

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