Option Investor Rationality Revisited: The Role of Exercise Boundary Violations

Our empirical results overturn the well-known textbook theory that American options should not be exercised early except in very limited conditions. In the real world, the best bid available in the market is frequently below the option’s intrinsic value (e.g., nearly half of all quotes for in-the- money calls), which we call an “exercise boundary violation” (EBV). In an EBV, early exercise can be the right strategy and the “American” option characteristic has economic value. Some option holders do exercise, some sell at EBV bid prices, and our results suggest that actual exercise behavior is much less irrational than earlier studies concluded.