Option Investor Rationality Revisited: The Role of Exercise Boundary Violations

Key Findings

Numerous studies have noted that options are often exercised early and concluded that investors behave irrationally. In this study, we pay careful attention to intraday option quotes and reach the opposite conclusion: early exercise is often the rational choice for options investors. The reason for this counter-intuitive result is simply that an option’s bid price is frequently less than the option’s intrinsic value. In these situations, selling at the bid price would yield fewer dollars than exercising the option and thus exercise becomes the rational choice

Abstract

Do option investors rationally exercise their options? Numerous studies report evidence of irrational behavior. In this paper, we pay careful attention to intraday option quotes and reach the opposite conclusion. An exercise boundary violation (EBV) occurs when the best bid price for an American option is below the option’s intrinsic value. Far from being unusual, we show that EBVs occur very frequently. Under these conditions, the rational response of an investor liquidating an option is to exercise the option rather than sell it. Empirically, we find that the likelihood of early exercise is strongly influenced by the existence and duration of EBVs. Not only do these results reverse standard theory on American option valuation and optimal exercise strategy, but they also suggest that the ability to avoid selling at an EBV price creates an additional source of value for American options that is unrelated, and in addition to, dividend payments. This additional value may help explain why American options appear overpriced relative to European options.