Option bid‐ask spread and scalping risk: Evidence from a covered warrants market

This study develops and empirically tests a simple market microstructure model to capture the main determinants of option bid‐ask spread. The model is based on option market making costs (initial hedging, rebalancing, and order processing costs), and incorporates a reservation bid‐ask spread that option market makers apply to protect themselves from scalpers. The model is tested on a sample of covered warrants, which are optionlike securities issued by banks, traded on the Italian Stock Exchange. The empirical analysis validates the model. The initial cost of setting up a delta neutral portfolio has been found to be an important determinant of option bid‐ask spread, as well as rebalancing costs to keep the portfolio delta neutral. This result provides evidence of a further link between options and underlying assets: the spread of the option is positively related to the spread of its underlying asset. Empirical evidence also indicates that the reservation bid‐ask spread, computed as the product of option delta and underlying asset tick, plays a very important role in explaining the bid‐ask spread of options. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:843–867, 2006