A Profitable Call Spreading Strategy on the Cboe

Abstract

We examine delta-neutral call spreading strategies on the Chicago Board Options Exchange between January 1987 and December 1989 and find substantial profits net of transaction costs. The suggested spread strategies are based on identifying discrepancies between the implied standard deviations of two related calls.In designing the trading rule, we are careful to ensure as much as possible that the indicated trades could have been executed, including requiring that the trading signal be confirmed by several actual prior trades, and that execution be delayed for up to ten minutes. Once established, the positions are kept delta-neutral by adjusting the spreads for every change of at least 10% in the hedge ratio. With lower transaction costs, we find that market makers and arbitrageurs earn up to five times the net profit of public traders. Profits are statistically significant for all traders except the public trader. Profitability is higher before October 1987, which may be the result of the decreased market transactions and volumes after the crash. Our strategy indicates there were three times more trading opportunities (spreads/month) prior to the crash. Vertical spreads (two calls differing only in their strike prices) are the most profitable. We also discover and exploit some interesting behavior of implied standard deviations as a call's maturity approaches.

JEL Classification: G13