The paper develops a new liquidity measure for the options market. Previous methods for measuring the liquidity of options - i.e. how easily and cheaply they can be traded - often reach their limits in practice. For example, they do not reliably recognize phases of great market uncertainty, falsely evaluate rarely traded options as particularly liquid and react sensitively to small changes in the structure of the option (e.g. whether it is in or at the money). To address these weaknesses, the paper presents a new method to measure option liquidity: the Elasticity-Adjusted Spread (EAS). Conventional measures such as the relative bid-ask spread - i.e. the spread between the buy and sell price relative to the option price - are often misleading for options because option prices can be very small compared to the underlying share price and react strongly to changes. Even small differences between options can therefore greatly distort the liquidity picture. The EAS addresses this problem by relating the trading spread to the amount needed to hedge the risk of the option by trading the underlying stock. In this way, the EAS measures the trading costs not relative to the (sometimes small) price of the option, but in relation to the actual economic risk associated with the option. This provides a much more robust and comparable picture of liquidity. Based on around 700 million option trades on US stock exchanges (2004-2021), it is shown that the EAS reliably recognizes market crises, is related to fundamental market variables and is also suitable in simplified form for broad use in science and practice.
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