ARBITRAGE IN THE MARKETS FOR CALL AND PUT OPTIONS

Dallas Brozik Professor of Finance Marshall University Division of Finance and Economics Huntington, West Virginia 2575-2320 (304) 696-2663 (304) 696-3662 FAX brozik@marshall.edu

ARBITRAGE IN THE MARKETS FOR CALL AND PUT OPTIONS

ABSTRACT Option pricing theory encompasses two distinct contracts, the call option and the put option. Existing option pricing models treat the two contracts as opposites that use the same relevant pricing factors in similar manners. These models also assume that the option market is efficient and unbiased. This paper examines the option market and finds it to be inefficient and biased in the pricing of call and put options. This difference in pricing behavior gives rise to profitable arbitrage opportunities by combining call and put options with an underlying stock.

INTRODUCTION Option pricing is one of the most researched areas of finance. Several different option pricing models have been developed, each with its own strengths and weaknesses. One common characteristic of these models is that call options and put options are treated as opposites by the pricing model. While this might be intuitively appealing, there is no a priori reason to believe that market participants price these contracts in an identical but opposite manner. Option prices reflect the behavior of the market participants, and if there is a difference between the behavior of the buyers/sellers of call options and the buyers/sellers of put options, then any option pricing model will need to reflect this difference in the pricing of the different contracts. Implicit to all symmetric pricing models is the assumption that the market in which the contracts trade is efficient. It would be possible to have symmetric pricing in an inefficient market if the mispricing incidents were randomly distributed, and such noise would make it difficult to test any theoretical pricing model. If the market were biased and

showed evidence of systematic mispricing, symmetric pricing models would not be possible.

LITERATURE REVIEW The Black-Scholes [1973] option pricing model provided a basis for a better understanding of the pricing of options and contingent claims securities. When applied to stock options, the model is able to explain much about how option prices are set, but there have been numerous studies that have found discrepancies between actual and predicted prices. Many researchers have attempted to explain these anomalies by changing certain characteristics of the model, like the interest rate specification process, and other researchers have focused on market factors like dividend payments to the underlying stock (for example, Black [1975], Black and Scholes [1973], Geske and Roll [1984], Gultekin, Rogalski, and Tinic [1982], MacBeth and Merville [1989], and Rubinstein [1985]). It should be noted that all of these researchers restricted their data to call options. Even the review of various option pricing models conducted by Bakshi, Cao, and Chen [1997] used only call option data. All of this research does have a common, though seldom expressed, characteristic. In all these models the pricing of the call option and the pricing of the put option are seen to be identical, though in opposite directions. The profit and loss diagrams for calls and puts are mirror images at maturity, so it is apparently assumed that while the option is active the same pricing mechanism is at work. This assumption is further supported by the acceptance of the put/call parity theory. Even though tests of the put/call parity theory show anomalies (Brenner and Galai [1986], Frankfurter and Leung [1991], Klemkosky and

Resnick [1979], Stoll [1969]), it is accepted as true, and this acceptance results in the assumed equal-but-opposite nature of call and put option prices. While all this work is indeed impressive and indicative of a similarity between the pricing of calls and puts, it has not yet been proven that the pricing models for these two different contracts are the same. The lack of testing of option pricing models using data from put options is no reason for the assumption of symmetry. Theoretical constructs notwithstanding, it is possible that call and put options are priced differently in their relevant markets.

METHODOLOGY AND DATA One of the difficulties in comparing call and put options is identifying comparable data points. Existing option pricing theory implies that there are several factors involved in setting the price of the contract such as time to maturity and the volatility of the underlying stock, and it can be hard to find data points that can be compared directly without having to make adjustments for specific contractual differences. There is, however, one situation that permits the direct comparison of the prices for call and put options. If the stock price closes at a strike price for an option, the call and put option prices for contracts with the same maturity should be equal if the pricing of the contracts is symmetrical. When the stock price closes at the strike price of an option, the only difference between a maturity-matched pair of call and put option contracts is that one is a call and one is a put. For example, if stock XYZ closes at 50 and there are matching call and put option contracts available for this stock at a strike price of 50, the parameters in the pricing models for the XYZ options with the same maturity would be identical. Both contracts

would have the same relevant volatility, time to maturity, and implied cost of capital. In a perfect market with symmetric pricing, all call/put combinations with matching maturities would have identical prices. In a less than perfect market with symmetric pricing, there could be differences in the call and put prices, but the differences should be randomly distributed, and there should be a similar number of occasions when the call price exceeds the put price as when the put price exceeds the call price. The less efficient the market, the noisier the market and the more price mismatches, but in a market with symmetric prices the price spread distribution would be balanced. The comparison of the prices of the call and put options in each observed price pair provides evidence of the symmetry or asymmetry of the call option and put option pricing processes. If the pricing processes are really symmetric, the prices of the call and put options will be the same, though some noise could occur due to market inefficiencies. This comparison also provides a direct test of the put/call parity theory. One specification of the theory is:

When the strike price and stock price are equal, the right side of the equation is either positive or zero. This implies that the price of the call option must be greater than or equal to the price of the put option, ceteris paribus. The existence of a significant number of cases where the price of the put option is greater than the price of the call option would indicate that put/call parity does not obtain and that option pricing models that assume put/call parity could be incorrectly specified. It is important to note that this process makes no assumption about the underlying option pricing model. The focus of this study is on the symmetry of the pricing of call and

put options. The question examined is one of market efficiency in pricing and does not provide evidence for or against any particular pricing model. The data used to examine the pricing of call and put options is from 2006. All options listed on the CBOE and traded during 2006 were used in this study. On those dates when the stock closed at an option strike price, the closing price of the call and put options with strike prices the same as the stock closing price were collected whenever there was a maturity-matched call/put pair. For example, if stock XYZ closed at 50 and there were both a call and put option with a strike price of 50 for a given maturity, the two option closing prices would comprise one observation. Since it is possible to have different maturity dates with the same strike price, it was possible to get more than one observation on each date. Not all contracts trade on all days, even if they are offered. On such days, contracts may have a bid and ask price, but the lack of market activity does not validate this price. Similarly, if only a few contracts are traded, the prices recorded for those contracts might reflect mispricing in a thin market. One further filter was placed on the data set in order to eliminate pricing anomalies that could be caused by light trading in one or both contracts. Only observations in which at least 100 call and 100 put contracts were traded were used. With this additional restriction, there were 1,580 matching pair observations.

RESULTS For each of the 1,580 valid matched-pair observations, the difference between the price of the call option and the price of the put option was calculated for each observation. The table below reports the relationship of the prices of the option pairs.

Price Relationship Call Price > Put Price Call Price = Put Price Call Price < Put Price Totals

Number of Occurrences 1079 208 293 1580

Percent of Sample 68.29% 13.16% 18.55% 100.00%

In 68% of the observations, the call price exceeded the put price while the put price exceeded the call price about 19% of the time. The relative number of mispricings indicates that the market is not symmetric. If the price differences are small, they could be considered noise in the trading process, but if the differences are large, they would be a sign of inefficiency. Put/call parity could be supported if the call prices were either zero or greater, but the frequency of occurrences when the put price exceed the call price cannot be dismissed simply as noise. Put/call parity does not appear to hold, but efficiency or inefficiency is not yet established. Exhibit 1 examines the pricing structure of call and put options. The number of mispricing incidents was calculated for each day to maturity in order to determine whether time to maturity played a role in option mispricing. Exhibit 1 shows that call options were more likely to be priced higher than put options and that this effect is especially pronounced as maturity increases. There is a difference in the pricing of call and put options. The nature of the difference in pricing behavior was examined by calculating the difference between the prices of the call and put contracts in each matching pair and comparing this difference with the time to maturity of the contracts. A graph of this relationship is shown in Exhibit 2. The slope of the line is 0.00276 (t = 22.2) and indicates

that on average a call option is worth roughly a quarter of a cent per day to maturity more than a put option. Recall that this observation does not test any underlying option pricing theory, but the nature of option prices that actually occur in the market does not support the concept of put/call parity. The existence of systematic mispricing between the markets for call and put options creates the possibility of arbitrage opportunities if the mispricing events are significant. If the differences are not significant, the markets could still be regarded as efficient if not symmetrical. There are two possible ways to exploit this mispricing. If the call is priced higher than the put, a hedged position can be formed by buying the stock, selling a call and buying a put. The profit/loss diagram for this hedge is shown in Exhibit 3. If the put is priced higher than the call, a hedge can be formed by short-selling the stock, buying a call and selling a put; this profit/los diagram is shown in Exhibit 4. The question of whether or not arbitrage is profitable depends on the spread between the call and put option prices, transactions costs, and the time value of money. If a stock is purchased, the time value of the investment should be considered. It is assumed that the account holding the proceeds from the options sale/purchase does not draw interest. The transactions cost on trading stock and option contracts will depend on the number of contracts traded. There are a number of on-line brokerages that execute stock trades for about $10 and options trades for about $10 plus a small additional fee per contract (usually less than a dollar). If a trader were dealing with only 100 shares of stock, the purchase/sale of the stock and the purchase/sale of the options would be about $.40 per share. If this same trader were dealing with 1,000 shares of stock, the total cost per share would be less than $.10. There are deep discount brokerage companies whose

commission schedules indicate that the appropriate stock and option trades for 1,000 shares could be done for around $0.03 per share. Exhibit 5 shows the number and proportion of profitable arbitrage opportunities that existed when the price of the call option was greater than the price of the put option. At a 6% cost of capital, there were 8 profitable arbitrage opportunities at a trading cost of $0.40 per share, but at a trading cost of $0.10 per share there were 85 profitable trades. Even at a cost of capital of 12%, there are 26 profitable trades at a trading cost of $0.10 per share. Exhibit 6 reports the number and proportion of profitable trades when put prices were greater than call prices, and the pattern is similar. What is interesting to note here is that though there were fewer arbitrage opportunities, there were usually as many or more profitable trades and a higher proportion of profitable trades than for instances when call prices exceeded put prices. This is in some degree caused by the fact that the short sale of stock only requires a 50% margin, and so the amount of borrowed cash was less. The number of profitable trades reported in Exhibits 5 and 6 were actually a very thin slice of the arbitrage available. These trades were restricted to situations with relatively high volumes of option trading, and it was assumed that no interest was earned on the margin accounts. Dividends were not considered; this would have increased the number of opportunities when call prices exceeded put prices and decreased the number when put prices were greater than call prices. These trades were all restricted to the specific cases when the closing price of the stock was equal to the strike price of the options. If stocks had been chosen that closed within $0.05 of the strike price, or some other appropriate range, there would have been many more instances where arbitrage was

possible. The number and magnitude of arbitrage opportunities cannot be regarded as random noise in the data.

CONCLUSIONS The development of any security pricing model often assumes that the market from which pricing data is obtained is efficient. If the market is not efficient or shows evidence of bias, any model which does not make allowance for this may be of limited value. It makes no difference how theoretically elegant a pricing model may be if it does not accurately reflect the market conditions. Existing option pricing models implicitly assume that calls and puts are opposite contracts and that the only difference between them is that one is a call and the other a put. Pricing models derived for call options are modified with properly placed negative signs and presented as pricing models for puts. This approach can only be valid if the option market is efficient and unbiased. This paper presents evidence that the market for call and put options is not efficient. These findings do not rely on any specific underlying model or assumptions concerning option pricing behavior. These results are based on market data for American style call and put options, and the data tell the story. Call options tend to be priced higher than put options, and there is a maturity component present; the markets are biased. Profitable arbitrage opportunities exist even when transactions costs are taken into account; the markets are inefficient. This implies that the concept of put/call parity does not obtain, and option pricing models that assume put/call parity may be inaccurate. The markets for call option and put options are not simply opposites; there are different pricing behaviors in

these different markets. Further research is necessary to identify option pricing models which take into account such differences in behavior.

REFERENCES Bakshi, R., C. Cao, and Z. Chen. 1997. Empirical Performance of Alternative Option Pricing Models, The Journal of Finance (December), 2003-2049. Black, F. 1975. "Fact and Fantasy in the Use of Options," Financial Analysts Journal (July/August), 36-41+. Black, F., and M. Scholes. 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy (May/June), 637-54. Brenner, M. and D. Galai. 1986. Implied Interest Rates. Journal of Business 59: 493-507. Frankfurter, G.M. and W.K. Leung. 1991. Further Analysis of the Put-Call Parity Implied Risk-Free Interest Rate. The Journal of Financial Research 14 (Fall): 217-232. Geske, R., and R. Roll. 1984. On Valuing American Call Options with the Black-Scholes European Formula, The Journal of Finance (June), 443-455. Gultekin, N., R. Rogalski, and S. Tinic. 1982. "Option Pricing Model Estimates: Some Empirical Results," Financial Management (Spring), 58-69. Klemkosky, R.C. and B.G. Resnick. 1979. Put-Call Parity and Market Efficiency. The Journal of Finance 34 (December): 1141-1155. MacBeth, J., and L. Merville. 1979. "An Empirical Examination of the Black-Scholes Call Option Pricing Model," The Journal of Finance (December), 1173-86. Rubinstein, M. 1985. Nonparametric Tests of Alternative Option Pricing Models Using All Reported Trades and Quotes on the 30 Most Active CBOE Option Classes from August 23, 1976 through August 31, 1978, The Journal of Finance (June), 455-480. Stoll, H.R. 1969. The Relationship Between Put and Call Option Prices. The Journal of Finance 24 (December): 801-824.

EXHIBIT 1

EXHIBIT 2
Call/Put Option Price Spread

EXHIBIT 3
Arbitrage When (Call Price) > (Put Price)

EXHIBIT 4
Arbitrage When (Put Price) > (Call Price)

EXHIBIT 5
Call Price > Put Price
Number of Profitable Arbitrage Opportunities at Various Costs of Capital and Price Spreads Price Spread (Call - Put) 0.00 0.03 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 Cost of Capital 6% 7% 326 250 225 174 164 127 85 58 51 39 37 27 21 18 16 9 9 8 8 7

1% 1053 999 846 664 526 429 349 284 238 200

2% 981 860 744 532 394 313 240 195 154 127

3% 841 685 551 376 265 198 133 104 76 64

4% 639 493 389 217 151 94 65 52 33 22

5% 446 318 234 124 78 50 40 25 15 11

8% 204 139 96 53 30 23 13 8 8 7

9% 169 120 85 42 24 18 12 8 7 7

10% 147 105 74 35 23 16 11 8 7 6

11% 130 97 67 29 21 14 8 7 6 6

12% 119 85 60 26 18 12 7 6 6 6

Relative Proportion of Profitable Arbitrage Opportunities at Various Costs of Capital and Price Spreads Price Spread (Call - Put) 0.00 0.03 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 Cost of Capital 6% 7% 0.3021 0.2317 0.2085 0.1613 0.1520 0.1177 0.0788 0.0538 0.0473 0.0361 0.0343 0.0250 0.0195 0.0167 0.0148 0.0083 0.0083 0.0074 0.0074 0.0065

1% 0.9759 0.9259 0.7841 0.6154 0.4875 0.3976 0.3234 0.2632 0.2206 0.1854

2% 0.9092 0.7970 0.6895 0.4930 0.3652 0.2901 0.2224 0.1807 0.1427 0.1177

3% 0.7794 0.6348 0.5107 0.3485 0.2456 0.1835 0.1233 0.0964 0.0704 0.0593

4% 0.5922 0.4569 0.3605 0.2011 0.1399 0.0871 0.0602 0.0482 0.0306 0.0204

5% 0.4133 0.2947 0.2169 0.1149 0.0723 0.0463 0.0371 0.0232 0.0139 0.0102

8% 0.1891 0.1288 0.0890 0.0491 0.0278 0.0213 0.0120 0.0074 0.0074 0.0065

9% 0.1566 0.1112 0.0788 0.0389 0.0222 0.0167 0.0111 0.0074 0.0065 0.0065

10% 0.1362 0.0973 0.0686 0.0324 0.0213 0.0148 0.0102 0.0074 0.0065 0.0056

11% 0.1205 0.0899 0.0621 0.0269 0.0195 0.0130 0.0074 0.0065 0.0056 0.0056

12% 0.1103 0.0788 0.0556 0.0241 0.0167 0.0111 0.0065 0.0056 0.0056 0.0056

EXHIBIT 6
Put Price > Call Price
Number of Profitable Arbitrage Opportunities at Various Costs of Capital and Price Spreads Price Spread (Put - Call) 0.00 0.03 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 Cost of Capital 6% 7% 237 229 199 188 145 139 84 79 60 51 43 40 33 29 28 26 24 23 21 21

1% 291 281 186 109 81 57 45 39 33 27

2% 283 262 176 104 75 55 44 38 32 25

3% 273 236 169 100 72 52 41 34 28 25

4% 260 222 160 93 69 48 38 32 28 22

5% 252 208 154 88 64 44 36 31 25 21

8% 217 177 129 74 49 37 29 24 21 19

9% 206 165 121 69 46 33 27 23 19 17

10% 195 154 118 63 45 32 26 20 18 15

11% 184 150 111 61 41 31 23 19 18 15

12% 177 142 106 58 39 27 22 19 18 15

Relative Proportion of Profitable Arbitrage Opportunities at Various Costs of Capital and Price Spreads Price Spread (Put - Call) 0.00 0.03 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 Cost of Capital 6% 7% 0.8089 0.7816 0.6792 0.6416 0.4949 0.4710 0.2867 0.2696 0.2048 0.1741 0.1468 0.1365 0.1126 0.0990 0.0956 0.0887 0.0819 0.0785 0.0717 0.0717

1% 0.9932 0.9590 0.6348 0.3720 0.2765 0.1945 0.1536 0.1331 0.1126 0.0922

2% 0.9659 0.8942 0.6007 0.3549 0.2560 0.1877 0.1502 0.1297 0.1092 0.0853

3% 0.9317 0.8157 0.5768 0.3413 0.2457 0.1775 0.1399 0.1160 0.0956 0.0853

4% 0.8874 0.7577 0.5461 0.3174 0.2355 0.1638 0.1297 0.1092 0.0956 0.0751

5% 0.8601 0.7099 0.5256 0.3003 0.2184 0.1502 0.1229 0.1058 0.0853 0.0717

8% 0.7406 0.6041 0.4403 0.2526 0.1672 0.1263 0.0990 0.0819 0.0717 0.0648

9% 0.7031 0.5631 0.4130 0.2365 0.1570 0.1126 0.0922 0.0785 0.0648 0.0580

10% 0.6655 0.5256 0.4027 0.2150 0.1536 0.1092 0.0887 0.0683 0.0614 0.0512

11% 0.6280 0.5119 0.3788 0.2082 0.1399 0.1058 0.0785 0.0648 0.0614 0.0512

12% 0.6041 0.4846 0.3618 0.1980 0.1331 0.0922 0.0751 0.0648 0.0614 0.0512