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Options University’s Options 101 - Part 21

Filed Under Options 101 

Options 101
Part 21
Table 2-6: CYBX Option Quotes
 
insert table21-1
Look at the asking prices of the first two listed calls, the June $12.50 and $15 strikes. The asking prices are $25.50 and $23, respectively, which is a $2.50 difference. And that’s exactly the difference in their strikes. Once the price of the $15 call is established by the market, the market will pay a maximum of $2.50 above that price for the $12.50 strike.
 
What’s the difference in prices between the $15 call and the $20 call? Their prices are $23 and $18, which is exactly $5 and, again, the difference in strikes. Once the price of the $20 call is established, the market will not pay more than $5 above that price for the $15 call.
 
These prices expanded to the full difference in strikes because the stock price was so far above them at expiration. In other words, these strikes were very deep-in-the-money. With the stock at $37.55, the market didn’t see a chance for any of these strikes to close out-of-the-money, so their prices converged to the exact differences in strikes. (You may have noticed that the difference between the $35 and $40 strikes is $5.10; this is simply a fluke. These quotes were probably in the process of being updated and you can be sure this fell to exactly a $5 difference in strikes.)
 
Now take a look at the $35 and $40 strikes. Their prices are $3.00 and 15 cents respectively, which is only a $2.85 difference. Here we have a five-dollar difference in strikes but only a $2.85 difference in price. Remember, this principle states that the difference in prices cannot exceed the difference in strikes. It does not say that it cannot be less. Because CYBX was trading for $37.55, neither the $35 strike nor the $40 strike are seen as being “guaranteed” to finish with intrinsic value at this time. That’s why the market is not pricing a full five-dollar difference in their prices.
 
There are two conditions under which you’d see a $5 difference between the $35 and $40 strikes. First, if stock’s price is sufficiently higher than these strikes, say $43, then you’ll see a five-dollar difference between the $35 and $40 calls. The more time that remains until expiration (or the more volatile the stock) the higher that stock’s price needs to be before you’ll see a $5 difference between these two strikes.
 
The second condition under which we’d see a $5 difference is if these quotes were taken in the final seconds of trading and the stock was $40.01 or higher. The sole determining factor is the market’s perception as to whether both of these options will expire in-the-money. If there is time remaining, then the stock’s price needs to be well above both strikes. If there is little time, then the stock’s price only needs to be just slightly above the higher strike in order for the difference in prices to be equal to the difference in strikes.
 
Now you should have a basic understanding of why this principle is true for any set of option quotes. If the option is deep enough in-the-money, the markets will view them as guaranteed to expire with intrinsic value, in which case the difference in strikes will equal the difference in price. Once risk is introduced though, the difference in their prices will be reduced to something less than the difference in strikes.
 
While option prices are free to fluctuate, there are invisible boundaries governing their prices. These are not rules set by exchanges or any person. Rather, they are economic and financial principles at work. Traders and investors who understand these six principles will be ahead of the game once we start talking about strategies.
 
 
The difference in the prices between any two calls (or any two puts) cannot exceed the difference in their strikes.
 
 
Key Concepts
1)      Lower strike calls and higher strike puts are always more expensive (all else constant).
2)      The longer the term to expiration, the more expensive the option (all else constant).
3)      Options are either worth zero or intrinsic value at expiration. Long options cannot have negative value.
4)      Prior to expiration, calls option are worth at least today’s value of the interest that could be earned on the exercise price.
5)      The maximum price for a call is the stock price. For puts, the maximum price is the strike price.
6)      The price difference in two calls (or two puts) cannot exceed the difference in strikes (all else constant).
 
Up to this point, we have covered some basic principles about option prices. We have looked at some pricing examples assuming the prices have already been set by the market. Let’s take the next step and ask a very important question: What gives an option its value in the first place?
 

What Gives an Option Value?
We’ve learned that an option’s price, or premium, can be broken down into the two component parts of intrinsic value and time value. If there is any intrinsic value present in an option, it must be reflected in the price; otherwise arbitrage is possible. The arbitrageurs make sure that options will always have intrinsic value. For example, if you have a $50 call and the stock is currently $53, we know that the call option must be trading for at least $3.
 
In addition to that $3 though, there will be an additional value – time premium – that is due to the fact that time still remains on the option. Part of this time value is derived from the cost of carry as Pricing Principle #4 showed. But traders are willing to pay more than this cost of carry since it gives the stock more time to build intrinsic value into the option. So even though the time premium will eventually be zero, traders are willing to pay for time since it gives the stock more of a chance to move in a favorable direction, thus making the option’s price go higher.
 
So up to this point, we know there are at least two factors that give an option value. The first is favorable stock price movement and the second is time. Favorable stock price movement means that if you are holding a call option, you’d like to see the underlying stock price rise. Remember that a call option locks in a buying price for the stock. The higher the stock price, the more valuable a call option becomes. For example, with the stock at $55, a $50 call must be worth at least $5. But if the stock rises to $60, the $50 call must be worth at least $10.
 
If you are holding a put, you’d like to see the underlying stock fall. Since a put option locks in a selling price, the further the stock falls, the more valuable put options become. For example, with the stock at $55, a $60 put must be worth at least $5. But if the stock falls to $50 the $60 put must be worth at least $10.
 
The second action that gives an option value is time. What drives the value of the time premium other than the cost of carry? We can clarify the point with an analogy. Imagine that someone makes you the following proposition: He will pay you $1 for every point scored above 20 by the end of an upcoming professional football game. For example, if the team scores 23 points, you are paid $3. If the team scores 32 points, you are paid $12 and so on. In exchange for this opportunity, you pay him a flat fee.
 
Now imagine that you are offered the same bet but for an upcoming basketball game. In either case, you’ll make money after 20 points, but does that mean that both bets have the same value to you? Think about it for a moment: Which would you pay more for, the football or basketball bet?
 
You probably realize that scores tend to be much higher for basketball than for football. It’s pretty rare that a football team will score more than 40 points but not uncommon for a basketball team to score more than 100. That means there is probably more money to be made from betting on the basketball team. In other words, because there is more “scoring potential” for basketball, the value of that bet should be worth more to you. No matter what you’re willing to pay for the football bet, you should be willing to pay more for the basketball bet. In this example, your perception about the scoring abilities between football and basketball teams leads you to believe that the basketball bet is worth more. The key word here is “perception.” It might turn out after the fact that the football bet was the better one to make. But prior to the games, your perception tells you that the basketball game is most likely the one that will produce the biggest reward.
 
As stated earlier, it is the “scoring potential” of the teams that drives the values of the bets. And that means that time plays a critical role since teams can produce higher scores the longer they are allowed to play. For example, if the basketball bet was only good for the first five minutes of the game then you should be willing to pay less than if it applied to the entire game.
 
To be continued….

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