Decomposing the bid-ask spread of stock options: A trade and risk indicator model
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This paper extends Huang and Stoll (1997) to develop a spread decomposition model that includes the costs of trading that are specific to the options market. The trade and risk indicator (TRIN) model includes separate inventory cost components that reflect the market maker’s delta, vega, and gamma risk. We find that adverse selection accounts for only 5.53% of option spread, is positively related to liquidity and leverage, and is higher given negative trade imbalances. Of the inventory risk, gamma risk is the largest component (7.01%), surpassing adverse selection risk, while vega risk accounts for 5.16% and delta risk is 4.12%.