One of the key market inefficiencies that we take advantage of in our option writing strategy is the pricing differential between out-of-the-money calls versus out-of-the-money puts. The causes of this pricing skew, and how one can profit from it, were recently written up in an excellent Futures Magazine article by James Cordier. If you've ever wondered why we favor writing puts above all other options plays, look no further than Cordier's explanation. He wrote:
In theory, calls and puts that are equidistant from being at-the-money (ATM) should be equal in price. After all, both supposedly have the same chance of finishing in-the-money (ITM). In fact, logic would say that the out-of-the-money (OTM) call should trade higher because it can theoretically go infinitely higher, while the OTM put stops gaining when the stock hits zero. And yet, in almost all cases, the OTM put trades higher, often significantly more than the OTM call.
For instance, let’s take a look at the exchange traded fund representing the S&P 500 (SPY). With SPY trading at 210 (as of noon March 5, 2015) it is ideal for illustration purposes. The April 200 put and the April 220 call are equidistant from being ATM. The April 220 call is trading at just 0.15, while the April 200 put is trading at 1.40—nearly 10 times more expensive! This is much higher than usual.
Why does this occur? There are a few reasons. One is that explosive moves in the stock market are far more often to the downside than to the upside. Another reason is that there is a natural supply imbalance in OTM calls due to the covered writers. Also, there is a natural demand imbalance in OTM puts due to the investors buying downside insurance.
The difference in prices between similar puts and calls are not always going to be close to 10 times, but our experience is that the puts are normally far more expensive than the calls. In fact, they generally trade at a price significantly above their theoretical value. This additional pricing above theoretical value is a significant source of our profit.