Journal Article10.2139/SSRN.2580548
Option Trading Costs Are Lower than You Think
Dmitriy Muravyev,Neil D. Pearson +1 more
TL;DR: In this article, the authors show that the bid-ask midpoint can be a poor proxy for the true value of a security, conditional on the occurrence of a trade, and that a large proportion of option trades exploit this high-frequency predictability to take liquidity at low cost, buying and selling immediately before option prices are expected to change.
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Abstract: Conventional estimates of the costs of taking liquidity in equity options markets are large. This presents a puzzle, which we resolve by taking seriously the implication of models of dynamic limit order markets that the bid-ask midpoint can be a poor proxy for the true value of a security, conditional on the occurrence of a trade. Changes in option prices can be predicted using publically available information, and a large proportion of option trades exploit this high-frequency predictability to take liquidity at low cost, buying and selling immediately before option prices are expected to change. Conventional measures of effective spreads and price impact do not account for this execution timing but can be adjusted to do so. For the average trade, effective spreads that take account of trade timing are one-third smaller than the conventionally measured effective spreads; for trades that reflect execution timing, they are four times smaller. Conventional measures of price impact overstate it by a factor of more than two. These findings have striking implications for the profitability of options trading strategies that involve taking liquidity. Our main results are robust to recent changes in option market structure.
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References
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News Trading and Speed
TL;DR: In this paper, the authors show that an investor's optimal trading strategy is significantly different when he observes news faster than others versus when he does not, holding the precision of his signals constant, and that price changes are more correlated with news and trades contribute more to volatility when the investor has fast access to news.
Issues in Assessing Trade Execution Costs
TL;DR: In this article, the authors assess the sensitivity of trading cost estimates to two methodological issues: the time adjustment made before comparing trades to quotes, and the procedure used to designate trades as buyer or seller-initiated.