The market spread,limit orders,and options

In this article the determinants of the quoted market spread of options are analyzed. The empirical model is based on an extension of the Ho and Stoll model of the market spread in a market with competing market makers and limit order traders. It is shown that the part of the liquidity that is supplied by limit orders vis-à-vis market makers is negatively related to the size of the market spread. This observation combined with regularities over the day in the thickness of the book of limit orders, allows us to offer a new explanation for the intraday pattern in the bid-ask spread. The article uses intraday data from the book of limit orders, transaction data, and quotation data.The author extends thanks to Bruno Biais, Phelim Boyle, Marius Jonkhart, Angelien Kemma, Teun Kloek, and George Sofianos for helpluf comments. This article was presented at the WFA-meetings in Jackson, the Financial Options Research Centre in Coventry, the EFA-meetings in Rotterdam, and the Conference on World Trading Markets at Vanderbilt University.