Index Option Anomalies: How Real Are They?

Abstract

We examine empirical “puzzles” documented in several high profile studies of the market for S&P 500 index options, such as the overpricing of out-of-the money (OTM) put options and at-the-money (ATM) straddles. We find that without any exception the theoretical bases of these studies have ignored persistent features of the index option market data such as the wide bid-ask spreads for OTM options, the partial segmentation of the market for puts and calls, and the inconsistency of the parameter estimates for different maturity options, which we document in our data. We present simple theoretical models of the end user option trader that incorporate these features and are parsimonious in terms of other assumptions. We find that these puzzles disappear under such conditions and conclude that these apparent anomalies are probably due to the omission of the above features.