Taking Money Off the Table: Suboptimal Early Exercises, Risky Arbitrage, and American Put Returns

Many studies report that American option investors often exercise their positions suboptimally late. Yet, when that can happen in case of puts, there is an arbitrage opportunity in perfect markets, exploitable by longing the asset-and-riskfree-asset portfolio replicating the put and shorting the put. Using early exercise data, we show that the arbitrage strategy also earns a highly significant mean return with low risk in real single-stock put markets, in which exactly replicating options is impossible. In line with theory, the strategy performs particularly well on high strike-price puts in high interest-rate regimes. It further performs well on short time-to-maturity puts on low volatility stocks, consistent with evidence that investors do not correctly incorporate those characteristics into their exercise decisions. The strategy survives accounting for trading and short-selling costs, at least when executed on liquid assets.