Journal of Financial Economics 8 (1980) 179-201. 0 North-Holland Publishing Company TRADING COSTS FOR LISTED OPTIONS The Implications for Market Efficiency* Susan M. PHILLIPS The University of Iowa, Iowa City, IA S2240, USA Clifford W. SMITH, Jr. Uniwrsity @‘Rochester, Rochester, NY 14627, USA Received October 1979, final version received March 1980 This paper reexamines the anomalous evidence concerning the efficiency of the listed options exchanges. We focus on the structure of trading costs m that market, and note several costs which generally have been ignored, the largest of which is the bid-ask spread. When we adjust the published trading rules for our estimates of these trading costs, the reported abnormal returns are eliminated. 1. Introduction and summary The efficiency of organized options exchanges is questioned in recent studies by Galai (1977, 1978), Trippi (1977), Chiras/Manaster (1978) and Klemkosky/Resnick (1979a, b). Although these authors all conclude their evidence is inconsistent with market efficiency, none of their studies carefully examines trading costs. As Jensen (1978) indicates, market efficiency implies that economic profits from trading are zero, where economic profits are risk- adjusted returns net of all zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHG costs. In this paper we analyze the structure of costs facing traders in the options markets. We examine the costs for traders who have a comparative advantage in arbitrage to determine whether trading costs are sufficiently large to eliminate the reported abnormal returns; if they are, market efficiency cannot be rejected and the inefficiency conclusion is unjustified. Oueruiew of the paper: In section 2, after summarizing the out-of-pocket costs of trading, we examine and estimate the transaction cost implicit in the *This research was partially supported by the Managerial Economics Research Center, Graduate School of Management, University of Rochester. We thank M. Jensen, W. Schwert, L. Wakeman, J. Warner, R. Watts, and J. Zimmerman and the referee, M. Rubinstein for their comments and criticisms of this paper.