Cheap Options Are Expensive

We show that options written on stocks with low prices are over-priced. This effect is robust to a variety of tests, controlling for common stock- and option- risk characteristics, and to reasonable transaction costs. Natural experiments corroborate this finding; options tend to become relatively more expensive following stock splits; and options on mini-indices are overpriced relative to options written on otherwise identical regular-priced indices. Our evidence suggests that (less sophisticated) retail investors consider options with low underlying prices as good deals due to low prices of such options. Demand pressure from these investors leads to option overpricing.