The intuition behind this research stems from the input of officers of derivatives exchanges and market participants who faced decreased liquidity in certain exchanges, especially during or after the financial crisis. This was more apparent in distressed countries, especially the ones that had to rely on support mechanisms in the European South, with the most prominent example being Greece. The interested parties realized that the authorities most likely had to take action in order to increase liquidity and they needed some answers in terms of whether it was solely an issue of the derivatives exchange authorities or the policymakers of the country as a whole. Consequently, investigating the impact of macroeconomic metrics, (equity) market characteristics, as well as perceived economic freedom to the liquidity of the derivatives market offers potential answers and paves the path for potential measures that if implemented, could assist in overcoming the exhibited illiquidity. As option markets have been in the spotlight this study investigates the determinants of their liquidity.

But why is there an interest in liquidity? Obviously there are many reasons for that. Starting with investors, it is clear that they cherish liquidity because it enhances the value of their assets. The ability to sell an asset without a large price change or impact enhances its attractiveness as a store of value. For the most part, this leads to a concern about average market liquidity, which varies greatly across asset classes even in normal market regimes. The global financial crisis highlighted the importance that liquidity has and its central role in well-functioning financial markets. Failure to adequately assess and manage liquidity underpinned major market turmoil, triggered unprecedented liquidity events and the ultimate demise of financial institutions such as Bear Stearns, Lehman Brothers that were previously thought too big to fail.

Liquidity is generally described as the ability to enter and exit in a trade easily thus encompassing a time, price and volume component. To identify liquidity in option markets professionals and researchers look at 4 option metrics; namely volume, open interest, bid-ask spread and implied volatility.

The problem many stock exchange policy makers face is the understanding of the full spectrum of factors that impact the liquidity of their option products and the option market sensitivity to various exogenous macroeconomic factors. The lack of clearly defined option liquidity factors used among professionals and the limited research being contacted about liquidity characteristics of option markets (as opposed to the extensive research on stock market liquidity) have deemed the policy making process of an option exchange a difficult endeavor.

Summing up, the contextual insight offered by the previous background is that liquidity is important for the investors, the intermediaries and the derivatives exchanges as it allows for more products (e.g. options with more strike prices and maturity dates), optimal pricing, easier trading (even block-trading), more efficient hedging and even speculation opportunities. Moreover, it allows for higher commissions due to higher volumes and not due to higher bid-ask spreads. In addition, it seems that both the market and the academia have agreed to the most relevant liquidity proxies, which are volume, open interest, bid-ask spread and implied volatility. What has not been investigated though is what drives these measures of liquidity.

It is therefore a valid research question to ask what the determinants of the option market liquidity are and what the stakeholders can do to increase it. The objective of this paper is to uncover the links between various macroeconomic factors and proxies of option liquidity metrics, especially examining the option markets of 15 European countries; thus, providing a framework for policy decision making regarding the facilitation of liquidity in option markets. Consequently, the novelties of this paper are identified in 1) the empirical assessment of the effect of macroeconomic indicators on option market liquidity with emphasis on exogenous factors that lie beyond the underlying market (of course, all factors that have been previously used in different studies are incorporated); 2) the incorporation of a greater number of proxies for liquidity compared to the existing research in the field; and 3) the identification of a series of directions that the policy makers can follow in order to increase the option market liquidity.

The remainder of this paper is organized as follows. Section 2 provides a brief review of the published literature. Section 3 sets the theoretical background of the problem. Section 4 describes the methods, approaches and data used. Section 5 presents our regression findings. Section 6 discusses our results and Section 7 the implications. Further research venues are recommended in Section 8, whereas Section 9 concludes our research.

The academic research in the area of financial product liquidity is extensive and whereas the derivative markets have been a subject of interest of numerous studies the current literature has not yet presented a satisfactory number of research papers on the liquidity of option markets. The majority of option liquidity research attempts to establish the relation of underlying market and option liquidity and focus on option market characteristics that shape liquidity. They do not address the macroeconomic variables or the economic freedom indicators that the present study employs.

Starting with its definition, as mentioned in the introduction liquidity is captured by the ability to enter and exit in a trade easily thus incorporating time, price and volume. This ability is translated and priced as cost which is measured as the mark down of a fire sale of a contract by an urgent seller. According to Shah et al. (2009), on average, a markdown equals to half of the bid-ask spread. Since brokerage commissions do not vary with the time taken to complete a transaction, differences in bid-ask spread indicate differences in the liquidity cost (Demsestz, 1968). To identify liquidity in option markets professionals and researchers look at volume, open interest, bid-ask spread and implied volatility.

Liquid and heavily traded option contracts tend to have more strike prices, expiration dates, whereas bull and bear spreads, straddles and other strategies are offered, involving one or more contracts. Furthermore, a busy market with many participants typically has narrower spreads between the bid prices and the ask prices According to TD Ameritrade (2015), quoting a study by Henry Schwartz at Trade Alert, the top 132 most active names, or 3% of listed options, see roughly 80% of total trading volume. In other words, the bottom 97% sees only 20% of the options volume. Clearly, the deeper liquidity pools are concentrated in a handful of names in the options market these days.

Mayhew et al. (1999) examined how the daily order flow in options is related to the characteristics of the underlying stock suggesting that option liquidity is positively correlated with stock price volatility and trading volume.

Kalodera and Schlag (2004) suggested that frequency and volume of option trades is positively correlated with stock volume based on their findings studying the German option market.

Capelle (2001) examined implied volatility and its implications on option market liquidity taking into account the volatility trades that take part in such markets. He proposes that for an optimal strategy in option markets you have to account for the percentage of liquidity traders and volatility traders. Consequently, bid and ask prices and thus liquidity in two different markets are functions of these percentages.

Cao and Wei (2010) discovered that commonality for various liquidity measures is strong, while information asymmetry influences liquidity in option markets more than inventory risk and suggested that the option liquidity is linked to the underlying stock market’s movements.

Wei and Zheng (2010) empirically examine the impact of trading activities on the liquidity of individual equity options as measured by the proportional bid-ask spread to find that (a) the option return volatility has a much higher explanatory power in explaining the spread variations compared with the stock return volatility and the option trading volume; (b) after controlling for the endogenous liquidity determinants (measures) there is a maturity substitution effect; and (c) there is a moneyness substitution effect induced by the stock return volatility.

Battalio and Schultz (2011) find that regulatory restrictions, such as the short sale ban, produce uncertainty that can impact the option market liquidity, as they lead to significantly increased bid-ask spreads for options on the banned stocks.

Chaudhury (2015) searches for quantitative measures of option liquidity. He shows that the relative spread measure, defined as bid-ask spread over the mid-price, does not rank options in terms of their liquidity in line with the popular view and leads to a bias against lower-prices options. He therefore recommends two alternative measures of option liquidity; namely the implied volatility of the underlying asset and the bid, ask and mid option prices in terms of implied volatility. By employing these liquidity measures he produces a ranking of options in terms of their liquidity that seems to be more in line with the common knowledge.

Gueant (2016), and Guéant and Pu (2017) look at liquidity from two angles: (a) the type of orders Gueant (2016) and (b) the optimal execution of orders Guéant and Pu (2017). More specifically they investigate (a) different types of orders that can achieve optimal liquidation Gueant (2016) and (b) Guéant and Pu (2017) how the models that are available for the optimal execution of orders can be used to price and hedge equity derivatives. For the former they utilize the Almgren-Chriss framework to deal with different types of orders, such as Target Close, Percent of Volume (POV) and Volume-Weighted Average Price (VWAP) orders. For the latter they employ this model to rather generalize the classical option pricing models by introducing execution costs and permanent market impact. The Almgren-Chriss framework models the optimal pace to build or unwind a position, i.e. to schedule the execution.

Bernales et al. (2018) find evidence that there is a liquidity searching behavior of informed investors in option listings and that the option bid-ask spread may still be a good proxy for informed trading besides this liquidity searching behavior. They show that there is an upward trend in the bid-ask spread of options after option introductions. This is most likely attributed to the fact that informed traders avoid trading in initial periods after listing dates due to low liquidity exhibited.

In summary, the present research is more in line with the studies of Mayhew et al. (1999), Kalodera and Schlag (2004), Capelle (2001) and Cao and Wei (2010), in the sense that it employs primarily the measures that they find to be good proxies of option price liquidity. However, it focuses on finding exogenous measures/determinants of option market liquidity and not endogenous as they did. The work of Wei and Zheng (2010) is not in the same wavelength with this study and that of the previous authors as they investigate an alternative liquidity measure that the present approach does not use. It however verifies the importance of the traditional liquidity measures, which are considered in this paper. The same pretty much holds true for the findings of Battalio and Schultz (2011). Chaudhury introduces variations of the option liquidity measures, which are not used in the present approach either, as it focuses on the traditional ones, thus following a different route. The direction of Gueant (2016), and Guéant and Pu (2017) is also different as they are not really addressing the determinants of option market liquidity, but rather investigate the impact of liquidity in order execution. The work of Bernales et al. (2018) also diverts from this paper; it however signifies the importance of liquidity and moreover verifies the use of bid-ask spread as a good proxy for liquidity. Consequently, the work deployed in this manuscript adds to the existing literature as it examines the option price liquidity from a new perspective; that of its dependence from a series of macroeconomic determinants of an economy, of market related factors and of economic freedom indices. In addition, as stressed earlier, it employs a bigger number of proxies and drafts directions that policymakers can follow in order to increase the option market liquidity. These points summarize the novelties introduced through this paper.

The intuition behind the topic of liquidity of option markets is the need of the derivatives exchanges to secure a level of liquidity that makes sense for the investors, the issuers as well as the exchange itself. Low liquidity makes the participation expensive and unreliable for the investors and results in a reduced interest. The latter discourages the participation of the issuers as well as of the derivatives exchange. An example is the Athens Stock Exchange, which has experienced an extremely thin trading as a result of the financial crisis that hit the Greek economy the most.

The question that the stock exchanges try to answer is what are the determinants of the liquidity of the option markets? To answer this question, one needs to agree first on the measures of liquidity. The obvious one is the volume of the options traded, as per Kalodera and Schlag (2004), Cherian (1999), as well as the open interest, as per Donders et al. (2000). The bid-ask spread tends to be high in illiquid markets; hence it is also considered a measure of liquidity (Cberian & Vila, 1997); Mayhew et al. (1999). Finally, the implied volatility also tends to be high in thinly traded markets, which makes it also a liquidity metric (Capelle, 2001 ; Cberian & Vila, 1997).

Most of the recent literature tackles the pricing of the (il)liquidity cost (Shah and Brorsen (2013). However, the interest of the derivatives exchanges is how to increase the liquidity and not to estimate its cost. In this respect, there are several directions that can be followed to find the determinants of the liquidity. One is to examine, the effect of certain variables related to the country. These are the macroeconomic figures, the capital market figures and the economic freedom indicators of each country of interest. The other, would be to consider the opinion of the market; i.e. contact market researches to the countries of interest that will map the consensus as of the level of fees that would be satisfactory for the intermediaries and acceptable by the investors as well as the additional steps that need to be taken by the responsible institutions, so that the liquidity increases.

In this research the first route is followed; i.e. the link between the option market liquidity as measured by volume, open interest, bid-ask spread and implied volatility with the variables that determine it is analyzed, as presented in the abstract and in section 5 below. Revealing this relationship can be helpful for the derivative exchanges and in particular the policy makers, as they can decide what country figures they need to improve so as to increase the liquidity of the derivative exchanges. Especially in a post-crisis era, the lack of liquidity is more structural and related to the country rather than the exchange itself. Countries that have been hit the most by the crisis are expected to experience lower liquidity in their options markets compared to the countries that weathered the crisis more successfully. Hence, tackling it requires a global approach rather than an instrument (derivative) specific approach.