The importance of stock liquidity on option pricing

This paper examines the impact of stock liquidity on option pricing by comparing pricing performance across two option pricing models. These two models are identical in all respects except for the presence of illiquidity in the underlying asset. Using various liquidity measures, the empirical results reveal a clear link between stock liquidity and option pricing. Specifically, adding a stock liquidity adjustment into an option pricing model produces smaller and more stable pricing errors for all comparison groups. The improvement rate is particularly high for options on stocks with lower liquidity and for out-of-the-money options. Our results are robust across liquidity measures and evaluation criteria. These findings highlight the significance of accounting for the stock liquidity when pricing options. (C) 2016 Elsevier Inc. All rights reserved.