Jan 14, 2015

Notes From Academia: Exercise Boundary Violations in American-Style Options

Here is the link to the research paper - Exercise Boundary Violations in American-Style Options: The Rule, not the Exception

Abstract: An exercise boundary violation (EBV) occurs when the current bid price for an American option in the market is below intrinsic value. A seller at this price leaves money on the table and the buyer receives an arbitrage profit. In a liquid market, competition among dealers should drive up the bid prices and eliminate the arbitrage. An analysis of intraday data shows that EBVs are the norm, not the exception, with near-term in-the-money equity calls and puts the most affected. In March 2010 48.6% of all in-the-money call options had EBV bid quotes and 11.5% of trading volume in those options occurred below the intrinsic value, costing the sellers an estimated $39 million. EBVs are highly persistent throughout the day, making it rational to liquidate an option by exercise rather than selling it in the market, in sharp contrast to textbook theory. Our empirical results show early exercise is strongly related to an option's EBV. 

The findings are not at all surprising: options market makers do not like to provide tight quotes for ITM options, especially high-delta options, because of pick-off risk. If market makes a sudden move, HFT stock traders, or options market makers with faster infrastructure can quickly trade against a slower market maker, locking in free premium. OTM options don't move as fast, and are not as risky from this angle.

So it is only natural that bids are below the exercise boundary. Majority of option traders know as much - if only 11.5% of volume is below intrinsic value, 88.5% presumably do not make that mistake.

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