CAPIS Capital Institutional Services : Stock Illiquidity and Option Pricing

SPX futures are off nearly 40 points to 1973 as the Kim Jong-un (aka: Supreme Leader, Marshal of the DPRK, First Chairman of the National Defense Commission, First Secretary of the Workers' Party, Chairman of the party's Central Military Commission, Member of the Presidium of the party's Political Bureau, and Supreme Commander of the Korean People's Army) is playing with his new toy today- a hydrogen bomb. Add this to the already hostile Iran/Saudi Arabia (aka Shi'ite/Sunni) tensions and we have equity futures off nearly 2%. The cash VIX finished 19.34 yesterday, but undoubtedly will spike on the open as all VIX futures have jumped this morning. The term structure is extremely flat pre-open with only a point range among all VIX futures (20.35 - 21.1).

Traders Magazine published an article last week titled Does Illiquidity of Stocks Influence Option Prices? The obvious answer is yes, which is no surprise to an ex-market-maker. The article discusses the new paper presented at the OptionMetrics Research Conference titled Stock Illiquidity, Option Prices, and Option Returns. Apparently researchers in the past were having a difficult time between the exact connection between illiquidity and option pricing, '..likely due to the effect that market makers are sometimes net long and sometimes net short in options.' Market-makers net long or short will have a definite impact on the absolute level of implied volatility (ie net long = lower IV, net short = higher IV) to be sure. The research concluded that the more illiquid the stock, the more the absolute level of IV will be exaggerated up or down. This is consistent provided the options trade. Many illiquid names have options with bid/ask spreads that are so wide (to ensure that market-makers get their hedges off) that no one really wants to trade them for negative edge (implied vol is dramatically different to realized volatility).

Illiquidity of the stock is definitely a factor to a market-maker of options. If the name trades 40,000 shares a day for example, why would I want to sell anywhere near 400 deep contracts or 800 fifty delta contracts in one day.. let alone one trade. Additionally, the bid/ask spread in the stock will dramatically affect where I price my bid/ask in the options. If I'm buying calls from a customer, I'm eyeballing the bid in stock for my hedge. If I'm selling calls, I'm looking at the offer in the stock. Wide bid/ask will make the option markets look really wide.

Getting back to the example above with a stock trading 40,000 shares a day.. I'm reminded of a trade that went wrong for some of my market-maker friends in another pit on the floor. Some customer came in and dropped 3000 at-the-money straddles on the crowd with a month left to expiration. As a market maker, when you buy options, you are buying volatility of the stock. A market-maker long contracts wants the stock to move, the more the better. In this case, the volatility may have been priced right at the time (IV = realized vol), but the absolute number of contracts just killed the stock. As expiration got closer, a market-maker net long straddles will dynamically hedge by selling stock above the strike and buying it below. This name traded 40k shares per day, and yet suddenly the net position in the crowd above the strike was 300,000 long and 300,000 short below the strike. The market for the stock couldn't absorb all of that and the market makers ended up pinning that stock to the strike on expiration. Ouch.