Are investors on average overly fearful/greedy regarding overall stock market volatility, and therefore willing to overpay for insurance/leverage in the form of broad market index options? If so, what reliable strategies could a trader use to exploit this fear and capture the overpayments? In their January 2006 paper entitled “Option Strategies: Good Deals and Margin Calls”, Pedro Santa-Clara and Alessio Saretto investigate potential mispricings of S&P 500 index options and a range of trading strategies that might exploit those mispricings. Using daily S&P 500 index options data from the Chicago Mercantile Exchange for January 1985-May 2001 and from the Chicago Board Options Exchange for January 1996-May 2004, they conclude that:
- Downside protection (via puts) generally costs more than upside leverage (via calls).
- In general, the best strategies involve buying far-maturity calls, selling near-maturity calls and holding only short positions in puts. For example, shorting straddles and strangles yields annualized Sharpe ratios of about 2 (without transaction costs and margin calls). These results are significant even if market crashes occur more frequently than seen in the sample data.
- Transaction costs, driven mostly by large bid-ask spreads, severely reduce the Sharpe ratios of option strategies.
- Margin calls negatively impact trading strategies in three ways: (1) they limit the size of short positions; (2) they force investors out of trades at the worst times; and, (3) they force more trading, thereby exacerbating transaction costs.
- With transaction costs and margin calls, the annualized Sharpe ratio of shorting near-maturity, out-of-the-money strangles decreases from 1.83 to 0.16.
In summary, investors/traders are generally willing to overpay for insurance and leverage via options, but only the market makers can consistently exploit this willingness.
