Option Strategies for Earnings Announcements: A Comprehensive, Empirical Analysis

3. Liquidity Risk: Bid-Ask Spreads

Liquidity refers to the ease of entering and exiting a position. It is determined by two factors: trading volume and the bid-ask spread. The two factors are related. Most of the time, when trading volume is high, bid-ask spreads tend to be narrow, and vice versa. For most retail investors, the trading volume of options is not an important constraint (though it can be a significant constraint for large institutional investors). Thus, we focus on the bid-ask spread as the main measure of liquidity in this chapter. We argue that bid-ask spreads in the options market can significantly alter the profitability of strategies. This is because bid-ask spreads in the options market are often prohibitively large when compared ...