We’ve just been introduced to real call and put options and now understand how to interpret their prices when looking at quotes. But did you notice in Table 1-1 that some options are more expensive than others? Why is that? And is there a pattern we should understand? This chapter takes you through some of the most important pricing principles of options. Understanding these principles is essential for mastering option strategies.

 

If you look at the prices in Table 1-1, you’ll notice that the lower strike calls are more expensive than the higher strikes. This will always be true assuming, of course, that all other factors are the same. That is, we must be looking at strikes on the same underlying stock and expiration month. For example, Table 2-1 shows the call prices for July from Table 1-1. Why do the prices get cheaper as we move to higher strikes?

                   Table 2-1

 

There are many mathematical reasons why this relationship must hold and we’ll look at one shortly. However, you already know enough to figure it out intuitively by thinking back to the pizza coupon analogy. Imagine that you walked in to buy a pizza and found the following two coupons lying on the counter:

 

insert pizza1       insert pizza2

Notice that both coupons control exactly the same thing (one large three-topping pizza) and have the same expiration date. The only difference is that the coupon on the left allows you to buy the pizza for $10.00 while the one on the right gives you the right to buy it for $20.00. If both pizza coupons allow you to do exactly the same thing but one just allows you to do it for a cheaper price, then obviously you would choose to pay the cheaper price. You should pick up the coupon that gives you the right to buy the pizza for $10.00.

 

The same thought process occurs in the options markets. For example, both the $32.50 call and the $35 call in Table 2-1 allow the trader to buy 100 shares of eBay, so there are absolutely no differences in what those two coupons allow you to buy. However, the $32.50 allows you to buy the 100 shares for less money. Traders realize the benefit in paying $32.50 rather than $35, so they will compete in the market for that coupon. It is a more desirable coupon, so traders and investors will bid its price higher than the $35 coupon. The same process happens all the way up the line. Each successively lower strike is bid to a higher price. Or conversely, each higher strike is bid lower than the strike below it. When you get into strategies, there will be times when you need to figure out which call option is more valuable. You can always find the answer by asking yourself which is more desirable. The answer to that question is the one that has the lower strike price. As our first Pricing Principle states: Lower strike calls must be more valuable.

 

This same reasoning drives many decisions in the financial markets. If it is more desirable then it must cost more with all other factors constant. Consider government bonds. Why are government bond yields lower when compared to the same face amount and maturity as a corporate bond? The reason is that government bonds are guaranteed; corporate bonds are not. So if a government bond and corporate bond both mature to $10,000 at the same time, which would you rather have? Again, there is no difference in what either of these bonds promise. Both promise $10,000 to be delivered to you at the same time. However, there is a big difference in the ability to carry out that promise. The government bond is far more secure so it is more desirable to investors. Investors will therefore pay a higher price for the government bond. And when bond prices rise, yields fall. That’s why government bonds will always have a lower yield than corporate bonds of the same face value and maturity.

 

When first attempting to understand option prices, you must remember that “more desirable” equates to more money with all other factors the same. If you do, you’ll understand many aspects of strategies that many traders must memorize

 

Now let’s take a look at why higher strike puts are more expensive. Table 2-2 is a listing of the July put options from Table 1-1:

                 Table 2-2

With the put options, the reverse appears to be true and the higher strike puts are more expensive. Why does this pattern occur? The reasoning is similar as it is for calls but you must remember that put options allow you to sell stock. If all prices were the same, which put option would you rather have? In other words, which strike price is more desirable? Obviously, it is more desirable to sell your shares for $40 than for $37.50, so traders will bid the prices of the $40 puts higher than that of the $37.50 puts and the $37.50 puts will be bid higher than the $35 puts and so on down the line. Higher strike puts will always be more expensive than lower strike puts with all other factors the same (same underlying stock and expiration).

 

To better understand the relationship between put strikes and price, think about insurance. If you have a $30,000 car and want to insure it for the full value, you will pay a certain premium. However, if you accept a $500 deductible and only want insurance for the remaining value, you will pay a lower premium. If you accept a $1,000 deductible, you will pay even less. In exchange for assuming some of the risk, you will pay a lower premium. In other words, the higher the value of your car insurance, the higher the premium you will pay.

 

This same relationship holds for put options. In Table 2-2, if a trader owns 100 shares of eBay and buys the July $37.50 put, he is attempting to insure the stock for more than its current value of $37.11. For that coverage he will pay $1.40 premium. However, if he chooses to assume some of the risk, he can pay a lower premium. How can he assume some risk? He can choose lower coverage by selecting a lower strike price. For instance, if he chooses the July $35 put, he will pay on 50 cents for the coverage. But in exchange for that lower premium, he is assuming the first $2.11 in damage since the protection on his stock does not start until a stock price of $35.

 

As we’ve written before, put options can be thought of as a form of insurance. If you want high coverage (high strike prices) you will pay a larger premium for that. If you choose to accept some risk (lower strike prices) you will pay a lower premium. In other words, high strike puts cost more than low strike puts.

 

There’s another way to understand why lower strike calls and higher strike puts must be more valuable. We can do so by looking at different strikes from a probability standpoint. Let’s assume that a stock can only move between $0 and $100 with all prices equally likely at expiration. If you own a $50 call, then there is a 50% chance that you will have intrinsic value at expiration. In other words, the $50 call acts as an asset to “catch” all stock prices to the right of the strike. Obviously, the more prices it can catch, the greater the value of the call. What can we do if we want to catch more strikes? We can shift to a lower strike price such as the $25 strike as shown in the following diagram:

insert diagram14-1 

 

If we lower the strike from $50 to $25, you can see that we have far more area to the right for the stock price to land at expiration as shown by the white arrows. This shows that the $25 call must be more valuable than the $50 call because it allows the trader to potentially catch more intrinsic value. The reverse reasoning shows that higher strike puts must be more valuable since they catch more stock prices to the left of the strike price.

 

Stick with whichever method helps you to understand or visualize why lower strike calls and higher strike puts must be more valuable.

 

 

To be continued…

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