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Stock Options—Puts Are More Expensive Than Calls

Sebencapital

Published
19/12/23
Stock Options—Puts Are More Expensive Than Calls

For most stocks or indexes traded on exchanges, the prices of puts (Stock options to sell at a fixed price) are usually higher than calls (Stock options to buy at a fixed price).

When you compare options with strike prices that are equally far from the money (way higher or lower than the current price), the puts have a higher premium than the calls. Additionally, they have a higher delta, which shows the risk concerning how much the option might change in value based on shifts in the stock it's linked to.

Key Takeaways

  • Normally, options to sell at a fixed price (puts) usually have higher prices compared to options to buy at a fixed price (calls).
  • One reason for the price difference comes from something called volatility skew, which is the contrast in implied volatility among out-of-the-money, in-the-money, and at-the-money options.
  • The more distant the put option is from being in the money, the higher the implied volatility tends to be.
  • Call options that are even more out of the money become less sought after, creating an opportunity for investors to purchase inexpensive call options if they're willing to buy options that are far out of the money.

Price Determinants

The price difference is affected by volatility skew, which involves variations in implied volatility among out-of-the-money, in-the-money, and at-the-money options. Here's an example to illustrate this concept:

  • Let's say the SPX (Standard & Poor's 500 Stock Index) is trading close to ₹1,891.76.
  • One investor purchases a ₹1,940 call option (48 points above the current price)
  • that lasts for 23 days, paying ₹19.00 at the midpoint between the bid and ask prices.
  • Another investor buys a ₹1,840 put option (51 points below the current price) expiring in 23 days, paying ₹25.00 at the bid/ask midpoint.

There's a significant price difference between the ₹1,940 and ₹1,840 options, especially considering the put option is three points further out of the money. This benefits the bullish investor (optimistic about the market) who can buy single call options at a relatively good price. However, the bearish investor (pessimistic about the market) wanting single put options faces a penalty, paying a higher price for those options.

Interest rates are also a concern for investors because they impact option prices. When interest rates are higher, calls tend to cost more. In 2019, interest rates were around 2.5%, which wasn't a factor for traders at that time.

The reason behind inflated puts (or deflated calls) is due to something called volatility skew.

  • When the strike price goes down, the implied volatility tends to increase.
  • When the strike price goes up, the implied volatility typically decreases.

Supply and Demand

Options have been traded on an exchange since 1973. Observers noticed that even in bullish markets, there were rebounds to new highs. When the market declined, those declines tended to be more sudden and severe compared to the advances.

Looking practically at this: Investors who always liked holding some out-of-the-money (OTM) call options might have seen success in some trades over the years. However, these wins usually happened only when the market made substantial quick gains, and those investors were prepared for it.

In most cases, OTM options end up worthless (when their value is less than the market value). Overall, having inexpensive, distant OTM call options tends to be a losing move for many investors.

People who owned far OTM put options saw their options expire worthless more frequently than call owners. But occasionally, if the market fell rapidly, the price of those distant OTM options skyrocketed, driven by two reasons.

How a Market Fall Affects Options

Initially, when the market drops, the value of puts goes up. Secondly (and notably in October 1987), option prices rise because nervous investors wanted to have put options to safeguard their portfolios, even if they didn't fully understand how to price them. These investors paid very high prices for these options.

It's important to note that put sellers were aware of the risk and demanded substantial premiums from buyers who were unreasonably selling those options. Investors willing to buy puts at any cost caused the volatility skew during that period.

Over time, buyers of far out-of-the-money (OTM) put options occasionally made substantial profits, which kept their hopes alive. However, owners of far OTM call options did not experience the same success.

The losses faced by far OTM owners were significant enough to change the mindset of conventional options traders, especially the market makers who provided most of those options. Some investors still keep a supply of puts as protection against a disaster, while others do so in hopes of hitting the jackpot someday.

A Changing Mindset

Following Black Monday (October 19, 1987), many investors and speculators favored the idea of consistently having some low-cost put options. However, immediately after the event, affordable puts were scarce due to the high demand for them. As the markets calmed down and the decline ceased, overall option prices settled into a new standard.

This new normal might have caused the disappearance of inexpensive puts initially, but they often returned to price levels that made them affordable for people to buy. Market makers found that the most effective way to raise bid and ask prices for any option was by increasing the estimated future volatility for that specific option.

This method proved to be efficient for pricing options. Another factor that influences option pricing is:

  • The more distant the put option is from being in the money, the higher the implied volatility tends to be. This means that sellers who usually sell very cheap options stop doing so, causing demand to be higher than the supply. This increased demand pushes up the price of puts.
  • On the other hand, even more distant out-of-the-money (OTM) call options become less sought after. This situation creates an opportunity for investors willing to buy OTM options that are far enough, but not too far, to find cheaper call options available.

The table below displays the implied volatility for the 23-day options mentioned earlier in the example.

STRIKE PRICEIV
183025.33
184024.91
185024.60
186024.19
187023.79
188023.31
189022.97
190021.76
191021.25
192020.79
193020.38
194019.92
195019.47
Implied Volume for 23-day SPX options on a single trading day

Frequently Asked Questions (FAQs)

Are puts riskier than calls?

Over a lengthy period, puts have generally been riskier because stock prices tend to increase compared to other assets. There are exceptions, like when a company goes bankrupt. But for individuals thinking about long-term calls and puts on a broad market ETF like SPY or QQQ, puts are usually the riskier choice. However, as the time frame shortens, puts and calls become more equally risky.

How do you collect option premiums?

Certain options traders focus on "selling premium." They seek out options with high premiums that they think will become worthless upon expiration, and they sell these options. These traders receive premiums immediately upon selling the options. If the options do expire worthless, the trade ends, and they retain the premium they collected.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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