How should we deal with the wide bid-ask spreads in pricing option contracts?
What is it about?
Bid-ask spreads in equity and, especially, index options are very wide. Most of the pricing models in the academic and professional literature have ignored them, as well as all other types of proportional transaction costs. I attribute this neglect to the incompatibility of such costs with popular methodological approaches in modeling options and provide alternatives to these approaches. I also show with out of sample tests that these alternatives can also help us identify profitable trading opportunities in the index option markets.
Why is it important?
The techniques described in the article would allow portfolio managers to increase return without acquiring extra risk. All proofs are out of sample and model free, unlike most empirical option research. Last, the empirical work uses actually observable bid and ask option data without arbitrarily selecting a single value out of the bid-ask spread.