Liquidity Costs in Futures Options Markets

The major finding is that liquidity costs in futures options market are two to three times higher thanliquidity costs in the futures market. Liquidity cost is one potential factor to consider when choosingbetween hedging with a futures contract or with an option contract. While there is considerable researchthat estimates liquidity costs of futures trading, there is little comparable research about options markets.This study, for the first time, attempts to determine and compare liquidity costs in options and futuresmarkets. The study uses July 2007 wheat futures and options contracts traded on Kansas City Board ofTrade. Two measures of liquidity costs were used for both options and futures markets. One measure ofliquidity costs in options markets is the average bid-ask spread that is calculated from the available bidaskquotes. A new measure of liquidity costs in options markets is derived based on the Black model andit uses trade prices instead of observed bid-ask quotes. The liquidity costs in the options market wasestimated to be 1.60 cents per bushel using observed bid-ask spreads and it was 1.37 cents per bushelwhen the new measure was used. Liquidity costs in the futures markets are estimated using Roll’smeasure and average absolute price changes. The estimates were 0.45 and 0.49 cents per bushel,respectively for futures contracts. A positive relation was found between option liquidity costs andmoneyness of the option. Days to expiration of the contracts was not statistically significant in explainingthe liquidity cost of the option.