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Exercise Boundary Violations in American-Style Options: The Rule, Not the Exception

51 Pages Posted: 5 Jan 2015 Last revised: 2 Jun 2017

Robert H. Battalio

University of Notre Dame - Department of Finance

Stephen Figlewski

New York University - Stern School of Business

Robert Neal

Indiana University - Kelley School of Business

Date Written: March 1, 2015

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. In addition to altering optimal exercise strategy and the value of the early exercise premium, the possibility of early exercise to avoid an EBV makes intrinsic value the effective bid price. This narrows the spread and raises its midpoint, which affects customary measures of market liquidity, the option's market price, and its implied volatility.

This paper has been significantly revised and is available from SSRN under a new title: Option Investor Rationality Revisited: The Role of Exercise Boundary Violations at http://ssrn.com/abstract=2978812..

Keywords: American options, early exercise, options market-making, arbitrage

JEL Classification: G130, G140, G110

Suggested Citation

Battalio, Robert H. and Figlewski, Stephen and Neal, Robert, Exercise Boundary Violations in American-Style Options: The Rule, Not the Exception (March 1, 2015). Kelley School of Business Research Paper No. 15-10. Available at SSRN: https://ssrn.com/abstract=2544915 or http://dx.doi.org/10.2139/ssrn.2544915

Robert H. Battalio

University of Notre Dame - Department of Finance ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States
574-631-9428 (Phone)
574-631-5255 (Fax)

Stephen Figlewski (Contact Author)

New York University - Stern School of Business ( email )

44 West 4th Street
Department of Finance Suite 9-160
New York, NY 10012-1126
United States
212-998-0712 (Phone)
212-995-4220 (Fax)

Robert Neal

Indiana University - Kelley School of Business ( email )

801 W. Michigan
Indianapolis, IN 46202
United States
317-274-3348 (Phone)
317-274-3312 (Fax)

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