Are out-of-the-money (OTM) call options a good way to speculate on spikes in the price of underlying stocks? In other words, are such options reliably underpriced or overpriced? In her August 2008 paper entitled “Stock Option Returns: A Puzzle”, Sophie Xiaoyan Ni investigates one-month returns for call options on individual stocks that do not have an ex-dividend day prior to expiration. Using expiration date option price data for a broad sample of qualifying stocks during January 1996 through June 2005, she concludes that:
- Out-of-the-money calls have negative average returns over the entire sample period. Options out of the money by more than 15% yield an average return of -28%.
- The higher the strike price, the worse the average returns for call options on individual stocks.
- The overpricing of out-of-the-money call options may derive from systematic overestimation, by options sellers and buyers, of the odds of a sharp rise in the price of underlying stocks.
The following chart, constructed from data in the paper, summarizes the average return across the entire sample period for one-month call options on individual stocks with no complicating ex-dividend events. Results are segmented by moneyness on the horizontal access, defined as the ratio of the option strike price to stock price on the purchase date. The analysis assumes rolling purchases of options at the midpoints of bid-ask spreads on each option-expiration Friday.
Note that the assumption of the bid-ask midpoint as the option purchase price is optimistic. Using the ask price instead may eliminate the positive returns for the at-the-money and in-the-money segments.
In summary, there is probably a substantial headwind for those speculating on stock pops by buying near-expiration, out-of-the-money call options. Selling such options may be reliably profitable.
