Review of Quantitative Finance and Accounting, 12 (1999): 395±413
# 1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
The Effect of Option Trading on the Structure of Equity
Seo-Kyeong University, Seoul, Korea
J. DAVID DILTZ
Finance and Real Estate Department, Box 19449, College of Business Administration, University of Texas at
Arlington, Texas 76019. E-mail: firstname.lastname@example.org
Abstract. This paper investigates empirically the direct effect of option trading on the structure of costs that
comprise the underlying equity bid-ask spread. Our results show that the spread declines over a 30-day period
following initiation of option trading, but the decline vanishes when price, volume, and volatility effects are
considered. Changes in the composition of the spread re¯ect primarily a reduction in adverse information costs.
Additionally, consistent with previous research, we ®nd signi®cant transaction-type clustering in our intraday
Key words: options, bid/ask spread, decomposition
JEL Classi®cation: G14, Market Ef®ciency and Information
This paper investigates the relationship between option trading and changes in the size and
composition of the quoted spread of the underlying equity. Several previous studies have
examined various dimensions of the impact of option trading on stocks. For example,
Skinner (1989) documented a decline in stock return volatility following initiation of
option trading. Damodaran and Lim (1991) found similar volatility changes. Fedenia and
Grammatikos (1992) documented changes in stock spreads following option trading, with
liquid stocks experiencing spread increases and illiquid stocks experiencing spread
decreases. This work is important in that any informational, volatility, or liquidity impacts
resulting from option trading may affect the underlying individual ®rm's cost of capital.
Moreover, given the popularity of traded options, option trading may affect stability of the
equity markets as a whole. Our research is a natural extension of Fedenia and
Grammatikos, in that we attempt to examine the structural source of changes in the stock
spread following option trading.
Beginning with the seminal work of Demsetz (1968), modeling of the quoted bid/ask
spread has been the subject of much research. The quoted spread is commonly recognized
to consist of three components; order processing costs, inventory holding costs, and
adverse information costs. Each component has been studied in detail by a number of
researchers. For example, Demsetz (1968) and Tinic (1972) focus on order processing
costs, while Amihud and Mendelson (1980) and Ho and Stoll (1981) attempt to model