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P. Pederzoli, H. Doshi and S. A. Sert: Risky Intraday Order Flow and Equity Option Liquidity

January 15, 2025

We examine the effect of intraday order flow volatility on option market illiquidity. We document a robust positive relationship between order flow volatility and illiquidity, both in time series and the cross-section of short-maturity index and individual equity options. The impact of order flow volatility varies significantly by option maturity, decreasing as maturity increases, underscoring the higher sensitivity of liquidity in ultra-short maturity options. We leverage multi-exchange trading of individual stock options to isolate the direct trade absorption costs from indirect costs. This analysis reveals that, while both cost components are significant, indirect costs dominate, with exchanges adjusting based on aggregate order flow risk across venues. Overall, our results contribute to the understanding of how effectively liquidity providers provide liquidity in this relatively novel market of short-maturity options.

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