I have two related questions: 1. For Euro style options, what keeps the premium up to date with the price of the underlying? In American style, the buyer of the option could exercise at any time if the price of the option was greatly out of line with the underlying, but for euro style that doesn't seem to be the case. My question is what (or who?) trades euro style options? What is the advantage to a market maker to place realistic bids and asks? 2. For SPX specifically, why are bid-ask spreads so wide? For longer dated options the spread appear to be wider than SPY, why?
1. Arbitrage between options and listed futures and the arbitrage between the implied vol derived from the trabeable price and the realized vol. same reason for American options. American options are not exercised early that often. The criteria is pretty strict. 2. The listed bid offer is wide but real bid offer is very narrow. you will trade on mid a lot.
The US markets (regardless of exercise style) mostly use a "Market Maker" system as liquidity providers. The MMs adjust the Bid/Ask when necessary (ie. when the underlying moves, time decays etc)... Quote from the above linked text:
In my view, even though you can't exercise European-style options like the SPX ones early, their prices still closely follow the actual stock prices. This happens because of how the trading world works—people and companies trading these options make sure prices are fair based on what's happening with the stock, using their strategies and rules. Also,the way SPX options are set up, including who trades them and how they're settled, plays a big part in why the prices you see to buy and sell (the bid-ask spreads) are the way they are.