Options Trading Costs Are Lower than You Think

Conventionally measured bid-ask spreads of liquid equity options are large. This presents a puzzle, which we resolve. At high frequency, changes in option prices can be predicted using recent changes in stock prices. A large proportion of option trades exploit this predictability to take liquidity at low cost, buying and selling immediately before option prices are expected to change. Conventional measures of effective spreads and price impact do not account for this execution timing but can be adjusted to do so. For the average trade, effective spreads that take account of trade timing ability are one-third smaller than the conventionally measured effective spreads; for trades that reflect execution timing, they are five times smaller. These findings have striking implications for the profitability of options trading strategies that involve taking liquidity. In addition, conventional measures of price impact overstate it by a factor of more than two. Our results also indicate that most option trades originate from investors who time executions, for example proprietary traders and institutional investors who have access to execution algorithms.