Why Puts Cost More Than Calls

Implied Volatility in Action

For almost every stock or index whose options trade on an exchange, puts are more costly than calls. Clarification: 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.

This is the result of a volatility skew. Let's see how this works with a typical example.

SPX (the Standard & Poors 500 Stock Index) is currently trading near 1891.76 (but the same principle holds whenever you look at the data).​
The 1940 call (48 points OTM) that expires in 23 days costs $19.00 (bid/ask midpoint)
The 1840 put (50 points OTM) that expires in 23 days costs $25.00

The difference between $1,920 and $2,610 is quite substantial, especially when the put is 2 points farther out of the money. Of course, this favors the bullish investor who can buy single options at a relatively favorable price. On the other hand, the bearish investor who wants to own single options must pay a penalty 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. Sure, interest rates affect option prices (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.

Why Does This Happen?

Since options have been trading on an exchange (1973), market observers noticed one hugely important situation: 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.

Let's examine this phenomenon from a practical perspective: The person who prefers 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 options is not a good strategy for most investors.

Despite the fact that owners of far OTM put options saw their options expire worthless far more often than call owners did, 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 puts more valuable. However, equally as important (and in October 1987 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 being "foolish enough" to sell those options.

That 'need to buy puts at any price' is the major factor that created the volatility skew. 

The bottom line is that 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 option traders, especially the market makers who supplied most of those options. Some investors still maintain 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 were 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 premium returned to the "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 drives prices even higher.
  • Further OTM calls options become even less in demand, and cheap options are available for investors willing to buy far-enough OTM options.

Here is a list of implied volatility for the 23-day options mentioned above.

Imp Vol for 23-day SPX options on one trading day
Strike Price         IV    
 1830   25.33
 1840   24.91
 1850   24.60
 1860   24.19
 1870   23.79
 1880   23.31
 1890   22.97
 1900

   21.76

 1910   21.25
 1920   20.79
 1930   20.38
 1940   19.92
 1950   19.47