Failure to Exercise

From the Spring 2012 edition of Vanderbilt Business

StockmarketNumbers-250The trading volume of stock options has more than quintupled in the past decade, as banks, hedge funds and other traders have flocked to the investments. But retail options investors may be getting left out in the cold, unknowingly giving up as much as $1.9 billion in lost profits during that same time frame, according to new research from Kate Barraclough, Lecturer of Finance and Director of the Master of Finance program, and Bob Whaley, the Valere Blair Potter Professor of Finance and Co-director of the Financial Markets Research Center.

The problem uncovered by the Vanderbilt team happens with put options—contracts that allow owners to sell an underlying asset at a specific price and within a certain time frame. (Put-option holders make money when the underlying asset price declines.)

Because American-style put options can be exercised anytime before they expire—as opposed to European-style options that can be acted upon only at expiration—investors must find the optimal point at which to close their positions. Otherwise they will forgo interest income that’s, in some cases, greater than their expected profit.

In the study, which will be published in a forthcoming Journal of Finance, Barraclough and Whaley develop a model to test when it’s most advantageous for investors to close put-option positions that are deep in the money. In other words, for put options whose underlying asset has declined to such a level that a maximum profit is all but assured, where is the point when it’s more advantageous to close the put-option position and instead collect the net interest income on the cash proceeds?

“A deep in-the-money put has no time value remaining and is priced at its floor value,” Barraclough and Whaley write. “The difference between forgone interest income and the value of future exercise opportunities determines whether the put should be exercised early or not.”

As it happens, professional investors appear to have realized that money is being left on the table. In response, they’ve developed an arbitrage strategy to capture the forgone interest of those who don’t exercise put options when it’s optimal to do so.

Barraclough and Whaley show that more than 3.96 million put options between January 1996 and September 2008—3.7 percent of all put options outstanding—were not exercised when they should have been. That cost long put-option holders more than $1.9 billion during that period.

In its simplest terms, when long put-option holders don’t exercise at the right time, short put-option holders can (and do) come in and snatch interest income.

Why do investors give up this money? One possible explanation lies in the additional trading costs for long put-options investors, according to Barraclough and Whaley. However, even when estimated trading costs are included, the Vanderbilt team still found nearly $1.82 billion in forgone net interest income.

Another reason is that retail put-option investors simply don’t know about—and don’t use—an appropriate early exercise decision rule.

“Both market makers and proprietary firms demonstrate that they know the early exercise decision rule and apply it in a timely and appropriate fashion,” Barraclough and Whaley write. “That is not to say that the nonprofessional traders are behaving irrationally. The costs of learning the early exercise decision rule and constantly monitoring open put-option positions may be too high relative to the perceived benefits.”

(In a similar 2007 study that Whaley co-authored, the researchers found that call option holders gave up an estimated $491 million during a 10-year period for failing to exercise the options on dividend-paying equities at the optimal time.)

Based on the finding of this most recent put-options study, Barraclough and Whaley say the bottom line is that long put-option investors are “implicitly paying a premium for the ability to early exercise that they rarely use.” In addition, market makers and proprietary firms are appropriating the potential gains of those in a short put-option position.

“Among other things, this raises fundamental concerns regarding contract design and market integrity,” they write. “If many option buyers pay for the right to early exercise but either cannot or do not take advantage of it as a result of exercise costs, unawareness of appropriate decision rules, inability to continually monitor open positions, or irrationality, would not the integrity of the market be better preserved with stock option contracts that are European-style?”

A version of this article originally appeared in VB Intelligence on Feb. 13, 2012.