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It is not well understood yet what drives price quotes (or illiquidity) dynamics in options market and whether there are any applications of options illiquidity for stock returns. We study the determinants of options bid-ask spreads using intraday transactions data for a large cross-section of …firms over an extended time period. We …find (i) hedging-related concerns by option market makers play important role in determining quoted and effective bid-ask spreads across all options categories, and rebalancing costs dominate initial delta-hedging costs; (ii) option demand pressures, as measured by order imbalances, have independent impact on options bid-ask spreads with comparable economic magnitude to the delta-hedging cost; (iii) information asymmetry, on average, also contributes to wider bid-ask spreads. Focusing our analysis around earnings announcements, we …find that option bid-ask spreads significantly increase around the announcement dates, providing support to informed trading in the options market.
If informed traders first chose to trade in options market before the information is incorporated in the prices of underlying, then options illiquidity should predict stock returns. Indeed, conditioned on options demand pressures, buy versus sell order flows, option illiquidity has strong predictive effect for stock returns. Options illiquidity increases associated with excess of options buy flows over sell order flows, i.e. dealers are widening spreads given excess of synthetic long positions in underlying compared to synthetic short positions, predict higher stock returns. This effect is stronger than using order flows alone and also results in higher economic magnitudes. The reverse is true as well. Wider bid-ask spreads associated with excess sell flows over buy flows predict lower stock returns. The evidence confirms that options market reflect information first and then gradually transmits it to the stock market.