Why Puts Cost More Than Calls
For almost every stock or index whose options trade on an exchange, puts command a higher price than calls. To clarify, when comparing options whose strike prices are equally far out of the money (OTM), the puts carry a higher premium than the calls. They also have a higher Delta. The delta measures risk in terms of the option's exposure to price changes in its underlying stock.
One driver of the difference in price results from a volatility skew.
See how this works with the following typical example:
- SPX (the Standard & Poors 500 Stock Index) is currently trading near $1,891.76 (but the same principle holds regardless of the stock's current price).
- The $1,940 call (48 points OTM) that expires in 23 days costs $19.00 (using the bid/ask midpoint).
- The $1,840 put (50 points OTM) that expires in 23 days costs $25.00 at the bid/ask midpoint.
The price difference between the $1,940 and $1,840 options is quite substantial, especially when the put is 2 points farther out of the money. Of course, this favors the bullish investor who gets to buy single call options at a relatively favorable price. On the other hand, the bearish investor who wants to own single put options must pay a penalty, or higher price, when buying put options.
In a normal, rational universe, this situation would never occur, and those options listed above would trade at prices that were much nearer to each other.
Interest rates affect option prices and calls cost more when rates are higher, but with interest rates near zero, that is not a factor for today's trader.
So why are the puts inflated? Or if you prefer, you may ask: why are calls deflated? The answer is that there is a volatility skew. In other words,
- As the strike price declines, implied volatility increases.
- As the strike price increases, implied volatility declines.
Supply and Demand
Since options have been trading on an exchange (1973), market observers noticed that, even though markets were bullish overall, and the market always rebounded to new highs at some future time, when the market did decline, those declines were on average, more sudden and more severe than the advances.
You can examine this phenomenon from a practical perspective: Investors who prefer to always own some OTM call options may have had some winning trades over the years. However, that success came about only when the market moved substantially higher over a short time.
Most of the time those OTM options expired worthless. Overall, owning inexpensive, far OTM call options proved to be a losing proposition. And that is why owning far OTM call options does not make a good strategy for most investors.
Owners of far OTM put options saw their options expire worthless far more often than call owners did. But occasionally, the market fell so quickly that the price of those OTM options soared, and they soared for two reasons.
First, the market fell, making the puts more valuable.
However, equally as important (and in October 1987 this proved to be far more important), option prices increased because frightened investors were so anxious to own put options to protect the assets in their portfolios, that they did not care or more likely, didn't understand how to price options, and paid egregious prices for those options.
Remember that put sellers understood the risk and demanded huge premiums for buyers being foolish enough to sell those options. An investor who felt the need to buy puts at any price was the major factor that created the volatility skew.
A Changing Mindset
Over time, buyers of far OTM put options occasionally earned a very large profit, often enough to keep the dream alive. But the owners of far OTM call options did not. That alone was sufficient to change the mindset of traditional options traders, especially the market makers who supplied most of those options.
Some investors still maintain a supply of puts as protection against a disaster, while others do so with the expectation of collecting the jackpot one day.
After Black Monday (Oct 19, 1987) investors and speculators liked the idea of continuously owning some inexpensive put options. Of course, in the aftermath, there was no such thing as inexpensive puts, due to the huge demand for put options. However, as markets settled down, and the decline ended, overall option premiums settled to a new normal.
That new normal may have resulted in the disappearance of cheap puts, but they often returned to price levels that made them cheap enough for people to own. Because of the way that option values are calculated, the most efficient method for the market makers to increase the bid and ask prices for any option is to raise the estimated future volatility for that option. This proved to be an efficient method for pricing options.
One other factor plays a role:
- The further out of the money the put option is, the larger the implied volatility. In other words, traditional sellers of very cheap options stopped selling them, and demand exceeds supply. That demand drives the price of puts higher.
- Further OTM call options become even less in demand, making cheap call options available for investors willing to buy far-enough OTM options.
The following table shows a list of implied volatility for the 23-day options mentioned in the example above.