Related topics

 

Options - Part two

“Moneyness” of Options.

Part one  |  Part two | Part three

As already explained in the previous article, the gain or loss on expiry connected with the use of options depends on whether the price of the underlying outperforms (for calls) or underperforms (for puts) the strike price.  For example a call option will be worthless on expiry if the price of the underlying is lower than the strike price: it will be more advantageous for the holder to buy the underlying on the market and the option will not be exercised.

An “at-the-money” (ATM) option is one where the strike price is equal to the current price of the underlying asset.

“In-the-money” (IN or ITM) refers to an option where the strike price is lower (call) / higher (put) than the current price of the underlying asset.

“Out-of-the-money” (OTM) refers to an option where the strike price is higher (call) / lower (put) than the price of the underlying asset.

To describe this in graphical terms, let us consider the case of a put option with a strike price of 14 Euros:

Values of the underlying that are below the strike price (ITM puts) will imply a gain and the exercise of the option holder’s right to sell at a price above market value; if, on the other hand, the underlying has a market value above the strike price (OTM puts), the option will not be exercised.  In the case of calls the exact opposite happens: if the value of the underlying is greater than the strike price, this will imply a gain and hence the exercise of the right to buy (ITM calls), conversely in the case of values of the underlying below the call (OTM) the option will not be exercised.

An option that is ITM on expiry is therefore one that would produce a gain if exercised: the extent of this gain is the option’s so-called intrinsic value, which represents the most important element of the price of an in-the-money option close to expiry.

But what are the other elements of the an option’s price?

The intrinsic value is not everything.  Let us consider an out-of-the-money option with a very long expiry: in this case the intrinsic value would be nil, however the very long expiry increases the probability that by the expiry date the derivative in question may be ITM.  The “price” that the option buyer is required to pay for this probability is called the time value, which logically decreases with the passage of time.  The time value also rises as the volatility of the underlying increases: clearly if the latter historically shows very significant fluctuations, the probability that OTM securities may be ITM on expiry will be greater.  In the mathematical models most commonly used to fix the price of options, the most important parameter and the one most difficult to calculate is precisely volatility to the point that on some circuits rather than the price of the derivative just the implied volatility at the various price levels is indicated, namely the volatility (as opposed to the historical and statistical volatility) which is implied in the price traded on the market at that moment in time.

Professional traders try to buy options (call or put options according to their expectations with regard to trend) if they anticipate a rise in volatility (the price of the options will increase) and sell them if they believe volatility will fall.

Lastly, the final price element of options derives from the play on supply and demand present in the market.  However, the variable concerned is not too significant, except in extreme cases.  These market imbalances do not last long because arbitrageurs implement strategies to take advantage from any lack of balance: without going into too much detail, it is enough to mention that by combining a put and the underlying it is possible to replicate the call, whereas with a short position on the underlying and long on a call the put is replicated.

We already explained the difference between European and American style options: the former can only be exercised on the expiry date, while the latter can be exercised at any time up to the expiry date.  As a result of this wider possibility as regards American options, their price is generally much higher and in any case never lower with respect to comparable European options (same duration, same underlying and identical strike price).   In actual fact, practice shows that American calls have the same price as European calls since they are rarely exercised prior to expiry.  In effect, in cases where calls are held for speculative purposes only, the commission systems, and the operating leverage they allow, lead to much higher gains (and losses) from buying and selling the derivative as opposed to exercising the right and operating on the underlying. 

On the other hand, where the intention is to buy the underlying with a view to holding it in portfolio, it is decidedly better to wait until the expiry date, since in this way the outflow of liquidity is postponed as long as possible and because to hold the call rather than the security provides a certain amount of protection against falls in the underlying (in case of a fall there is no capital loss and on expiry the underlying is purchased on the market at a lower price).