Stock illiquidity and option returns

Abstract

We provide evidence of a strong effect of the underlying stock's illiquidity on option returns. Conditional on end-user demand, illiquidity premiums are negative and decrease in stock illiquidity for options where end users are net buyers, while premiums are positive and tend to increase otherwise. Our results cannot be explained by common risk factors and cross-sectional differences in stock volatility or option spreads and are robust to different illiquidity measures and data periods. The observed pattern is consistent with an intermediary hedging cost channel and the magnitudes of our illiquidity premiums are in line with reasonable transaction costs.