CFA CFA Level 1 Derivatives – Option prices ~ Exercise prices

Derivatives – Option prices ~ Exercise prices

  • This topic has 10 replies, 6 voices, and was last updated Mar-17 by Snippy.
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    • Snippy
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      There are two statements which i’m not sure i completely understand, so if you can simplify and explain it, that’d be great!

      #1 Calls with lower exercise prices are worth at least as much as otherwise identical calls with higher exercise prices (and typically more).

      #2 Puts with higher exercise prices are worth at least as much as otherwise identical puts with lower exercise prices (and typically more).

    • cfaguru
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      Calls allow you to buy. Would you want to buy at a lower strike or a higher strike? Which call would you pay more to get? The one with the higher strike or lower strike?

      Think through it in a similar manner with puts.

    • Sophie Macon
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      Ooh, my favourite topic ;))

      The key to your questions is about the probability of exercise (or probability of being ‘in-the-money’).

      Call options = An option to buy assets at an agreed price on or before a particular date.
      With lower exercise prices, there is a higher probability of it being exercised.

      To put it visually, let’s refer to the classic “hockey stick” chart of a call option payoff.

      If the exercise price reduces, the area of the potential payoff increases. So it should be worth at least as much as the higher exercise price ones (all else constant). This explains statement #1.

      Similarly, put options = An option to sell assets at an agreed price on or before a particular date.

      Using the same logic of probability of exercise, the lower your put option price, the lesser the chance of it being in-the-money, as there is a lower chance of market price falling below the (lower) exercise price.

      Hope this helps, let me know if you have further questions.

    • Sarah
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      @SidMenon I think for this question an example would work best.

      If a stock is currently trading at $50 and you have a call option that has a strike price of $45 you are in the money and stand to gain $5 (I am ignoring time value of the option here just to make the example easier).

      Now if we take the same stock again but this time the strike price is $40 you stand to pocket $10.

      As we can see in the most simple case the call with the lower strike price must be worth more than a call with a higher strike price (assuming everything else is equal).

      This basic principle holds even when the options become more complicated.

      The reverse is true for put options.

      If we go back to the same stock and this time around we have a put option with an exercise price of $60 (you pocket $10) which is more than if the put options strike price is $55.

      Hope this helps!

    • Zee Tan
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      Everyone’s offered a different take, and here’s mine:

      A call is a right to buy.
      A put is a right to sell.

      Call: A right to buy something at a lower price (“I can buy this at a rock-bottom price compared to others”) is always going to be more valuable than a right to buy at a higher price.

      Put: A right to sell something at a higher price (“I can charge this dude a crazy-high price”) is always going to be more valuable than a right to sell at a lower price.

    • Sophie Macon
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      I think we’re all saying the same thing here, mine is the most long winded explanation :P, so try which works for you @sidmenon!

    • Snippy
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      Oh wow, the different takes just re-enforced this concept into my head. Thanks a bunch everyone! 😀

    • policedog
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      This helped me as well, thanks!

    • Snippy
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      I noticed that this post was shared on Facebook, @christine. Does this mean i have been certified as a genuine “question asker” ? 😛

    • Zee Tan
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      @Sidmenon I shared it. It was a good question that I thought others might want to know about! 😀

    • Snippy
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      That’s great to hear. Glad i could help others too. 🙂

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