COVID lockdown, Robinhood traders, and liquidity in stock and option markets

In this study, I investigate the impact of active option trading on stock market liquidity during the COVID-19 lockdown, particularly in connection with the rapidly growing retail trading activities during this period. I find that stocks with actively traded options, as well as those held by more Robinhood users, experience a lesser deterioration in liquidity during the US COVID-19 lockdown. However, a broader Robinhood user base appears to diminish the alleviation effect of actively traded options on the underlying stock's liquidity decline during the lockdown period. This observation is consistent with the postulation that informed traders shift away from option markets and towards stocks where the stock liquidity is improved. Further analysis suggests that, during the lockdown, a more extensive retail presence in the stock market is also associated with a narrower bid-ask spread in the option market. This finding supports the previous theories and empirical evidence suggesting that option market makers may offer tighter spreads when their hedging costs in the underlying market are reduced. Overall, this study presents novel evidence on the joint dynamics across stocks and options during the COVID-19 episode, and highlights the significant roles played by Robinhood traders in these dynamics.