Does accounting for realistic trading frictions support beliefs that equity index out-of-the money (OTM) put options and at-the-money (ATM) straddles are systematically overpriced? In their October 2018 paper entitled “Index Option Anomalies: How Real Are They?”, Michal Czerwonko and Stylianos Perrakis re-examine assumptions and data used in several high-profile studies finding that OTM put options and ATM straddles for the S&P 500 Index are overpriced, and that shorting these positions is therefore reliably profitable. They focus on the following aspects of option pricing: accounting for realistic trading frictions (bid-ask spreads); differences in pricing of same-strike price puts and calls; and, inconsistency in pricing across maturities. Using groomed intraday prices and quotes for S&P 500 Index (cash-settled) options 28, 14, and seven days to maturity during January 1990 through February 2013 (278 settlement dates), they find that:
- Past studies generally ignore (or incorrectly approximate) wide bid-ask spreads for OTM options, differences in pricing of put and call options and inconsistent effects of maturity on option prices.
- Using S&P 500 Index option bids and asks as trade prices and accounting for jump risk:
- There is very little evidence that OTM put options are overpriced.
- There is some insignificant evidence that ATM straddles are overpriced.
In summary, evidence indicates that selling OTM put options and ATM straddles on the S&P 500 Index is not attractive after accounting for realistic bid-ask spreads and other aspects of actual option pricing. In other words, prior research is defective.
Cautions regarding findings include:
- The analysis approach is abstract rather than practical and does not feature typical trading strategy performance metrics.
- Data used are somewhat stale.
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