Decomposing the bid-ask spread of a common stock: a cross-market approach

Existing trade-indicator models that estimate the components of the bid-ask spread of a common stock fail to utilize the trade flows in the options market as a potential source of adverse information. This paper develops a cross-market model to address this issue by introducing an option trade-indicator variable. Thus, the adverse information about a stock can be inferred from the trade flows of its related options as well as the stock itself. The empirical results support this innovation as there is a significant increase in the magnitude of the estimated adverse information component. This increase is more prominent when the option trade-indicator variable is based on high leverage options. These findings imply that informed trading takes place in the options market and informed traders prefer to transact in high leverage options. Intra-day variations in the distribution of stock bid-ask spread components are observed. The adverse information component is found to be highest when the market opens and declines throughout the day. On the other hand, the estimated inventory component remains steady throughout the day until the last hour of trading when it rises to the highest level. Furthermore, the stock bid-ask spread components are affected by the trade size of the stock and extent of imbalance in information-based option trades. When a large stock trade is observed in the last period, a larger estimated adverse information component of the stock bid-ask spread is obtained. Whereas, when a large imbalance in information-based option trades occurs in the last period, a larger estimated inventory component of the stock bid-ask spread is recorded.