The Effect of High-Frequency Market Making on Option Market Liquidity

Abstract

The transition from manual to electronic markets in options paved the way for pricing efficiencies and improved liquidity from options high-frequency market making (HFMM). We find that HFMM reduces option bid–ask spreads, although with differences across both option and firm characteristics. Depth increases with the number of market maker quote revisions, conflicting with extant high-frequency research in other markets. The largest absolute change for spreads (depth) is for mid-size (large) companies. However, the change to penny quotes for options caused HFMM to have less of an effect on both spreads and depth, showing that penny quoting exacerbates the pricing efficiency generated by more frequent quote revisions.

TOPICS: Exchanges/markets/clearinghouses, quantitative methods