PATTERNS AND DETERMINANTS OF THE INTRADAY BID-ASK SPREAD AND DEPTH OF CBOE EQUITY OPTIONS A Thesis Submitted to the College of Graduate and Postdoctoral Studies In Partial Fulfillment of the Requirements For the Degree of Master of Science in Finance In the Department of Finance & Management Science University of Saskatchewan Saskatoon By Junye Chen Copyright Junye Chen, December, 2017. All rights reserved. Permission to Use In presenting this thesis/dissertation in partial fulfillment of the requirements for a Postgraduate degree from the University of Saskatchewan, I agree that the Libraries of this University may make it freely available for inspection. I further agree that permission for copying of this thesis/dissertation in any manner, in whole or in part, for scholarly purposes may be granted by the professor or professors who supervised my thesis/dissertation work or, in their absence, by the Head of the Department or the Dean of the College in which my thesis work was done. It is understood that any copying or publication or use of this thesis/dissertation or parts thereof for financial gain shall not be allowed without my written permission. It is also understood that due recognition shall be given to me and to the University of Saskatchewan in any scholarly use which may be made of any material in my thesis/dissertation. Disclaimer The thesis was exclusively created to meet the thesis and/or exhibition requirements for the degree of Master of Science in Finance at the University of Saskatchewan. Reference in this thesis/dissertation to any specific commercial products, process, or service by trade name, trademark, manufacturer, or otherwise, does not constitute or imply its endorsement, recommendation, or favoring by the University of Saskatchewan. The views and opinions of the author expressed herein do not state or reflect those of the University of Saskatchewan, and shall not be used for advertising or product endorsement purposes. Requests for permission to copy or to make other uses of materials in this thesis/dissertation in whole or part should be addressed to: Head of the Department of Finance & Management Science 25 Campus Drive University of Saskatchewan Saskatoon, Saskatchewan, S7N 5A7, Canada i OR Dean College of Graduate and Postdoctoral Studies University of Saskatchewan 116 Thorvaldson Building, 110 Science Place Saskatoon, Saskatchewan, S7N 5C9, Canada ii Abstract This paper analyzes the intraday variation of option bid-ask spreads. We find an L-shaped spread pattern for options confirming the findings of Chan et al. (1995), a reverse U-shaped pattern for option depth, and a reverse S-shaped pattern for the underlying stock spread. In addition, we use regression analysis to analyze the determinants of the intraday spread of options. Our regression models are based on the findings of Cho and Engle (1999), De Fontnouvelle et al. (2003), Pinter (2003), Wei and Zheng (2010), and Verousis and Gwilym (2013). We extend this literature by considering the time-of-the-day effect. We divide each trading day into thirteen 30- minute intervals and use dummy variables to represent the various intervals of the day. In addition, we consider how the spread varies depending on whether the option is out-of-the- money, near-the-money, or deep in-of-the-money. This study uses intraday quote-level data obtained from the Option Pricing Reporting Authority (OPRA) for equity options listed on the Chicago Board Options Exchange (CBOE) during January, February and March of 2010. Consistent with the propositions of previous studies, for example Wei and Zheng (2010) and Verousis and Gwilym (2013), we find that option bid-ask spreads and percentage option spreads are significantly related to the spreads of the underlying stocks, option depth, time to expiration, moneyness, the number of quote revisions, volatility of underlying stocks, and market volatility. In addition, this study is the first to incorporate the underlying stock price as a determinant of the option spread. We propose that the underlying stock price is a proxy for the hedging costs incurred by option writers. We also discover that option depth is driven by many of the same factors that affect option spread, but the effects are mostly opposite in direction and the collective explanatory power of them for option depth is not as strong as the explanatory power for option spread. As most of the previous studies were conducted with end-of-day data, we confirm their results at the intraday level. In addition, we find that the underlying stock prices have positive effect on option spreads in general. We attribute this relationship to the hedging activities of the suppliers of options. Another unique contribution of this study is finding that the CBOE SPX Volatility Index (VIX) has significant and iii positive impact on option dollar spread, but it is insignificant with respect to percentage option spread. Also, it has a significant negative impact on put and call option depth. Although other factors may be important, we believe that information asymmetry theory can satisfactorily explain the intraday behaviors of option spreads in most cases. As market makers attempt to fulfil their responsibilities by providing liquidity to the market, they provide quotations based on their perception of risks, most critical of which is information asymmetry risk. To manage such risk, they use wide option spread as a cushion to compensate for taking the risk of trading with informed traders due to information disadvantage, and use low depth to lower the exposure to such risk. Regardless of the causes, we propose that option spreads are significant whether measured in dollar terms or as percentage of premiums, which suggests high transaction costs and high degree of inefficiency in the options market. The market is therefore most suitable for informed investors. Our L-shaped intraday pattern also suggests that timing of trades may be useful in this market, as during a typical trading day option spreads start relatively high in the morning and then drop to a more stable level after the first 90 minutes of trading. Moreover, we find that option spread and option depth are complementary in a sense that they both serve as tools for market makers to manage their inventories and risk exposure to limit potential loss. The spread and the depth are mostly negatively related. A notable exception is near the end of the day when market makers seem to maintain option spread but reduce the depth level, an action consistent with an attempt to avoid potential loss to informed traders. iv Acknowledgements The completion of this paper owes immensely to the intellectual inputs and consistent support from the author’s supervisor, Dr. George Tannous, Professor at University of Saskatchewan. His insights, guidance, patience and tolerance are what make this thesis possible. Much appreciation has to be given to Dr. Jason Z. Wei, Professor at University of Toronto, Dr. Craig Wilson, Associate Professor at University of Saskatchewan, and Dr. Fan Yang, Associate Professor at University of Saskatchewan, for their review and feedbacks, which significantly improved the quality and depth of this research. Besides, great thanks are due to all other staff and faculty members of MSc. Finance program at Edwards School of Business, including but not limited to, Dr. Abdullah Mamun and Dr. Marie Racine for their administrative arrangements and constructive comments. The author would also like to express sincere gratitude to all fellow students and colleagues in the program for their meaningful suggestions, to all staff in IT service office at Edwards School of Business for their prompt and efficient technical support, and finally to University of Saskatchewan for offering such a perfect platform for student researchers like myself. v Table of Contents Page Permission to Use i Abstract iii Acknowledgements v Table of Contents vi List of Tables viii List of Figures x Chapter 1: Introduction 1 Chapter 2: Literature Review 6 2.1 Explanatory Factors for Intraday Behaviors of Option Spreads 6 2.1.1 Option Depth 6 2.1.2 Underlying Stock Spread 7 2.1.3 Time to Expiration 7 2.1.4 Moneyness 8 2.1.5 Volatility of Underlying Stock and Option 8 2.1.6 Option Price 9 2.1.7 Intensity of Market Activities 9 2.1.8 Option Delta 10 2.1.9 Others 10 2.2 Theoretical Arguments for Microstructure 10 2.2.1 Microstructure of Options 10 2.2.2 Microstructure of Stocks 11 2.3 Observed Patterns for Spreads 14 2.4 Summary of Relevant Studies 17 Chapter 3: Theoretical Arguments and Hypotheses 21 3.1 Contributions by previous studies 21 3.2 Contributions of this study 23 Chapter 4: Data 27 4.1 Sample Period 27 4.2 Data Source 27 4.3 Raw Data and Sample Construction 27 vi 4.4 Data Cleaning 30 4.5 Data Preparation 31 4.6 Summary Statistics Related to the Key Variables 36 Chapter 5: Intraday Graphical Analysis 46 Chapter 6: Regression Analysis Models 64 Chapter 7: Empirical Results 72 Chapter 8: Robustness Check 109 Chapter 9: Summary, Conclusions, and Directions for Future Research 120 References 125 Appendix 128 vii List of Tables Table Number page number Table 1-1: Previous Studies of Intraday Option Spreads ··············································································· 1 Table 1-2: Main Variables in Option Spread Studies that Use End-of-Day Data ··········································· 3 Table 4-1: Selected Companies ···················································································································