ParT 2: ValuaTION, rISk aNd reTurN
the open market for $83.44. Buying
the March call option requires an
investment of just $2.15. The option
is inexpensive because there is only a
small chance that, before the option
expires in one month, Charybdis’ share
price will increase enough to make
exercising the option profitable. If an
investor pays $2.15 for the call option,
then Charybdis’ share price must reach
at least $87.15 before the investor earns
a net profit. That would represent a 4.4% gain on Charybdis shares in just a few weeks, so the low price of
the Charybdis call in part reflects that investors doubt the share will move that much in one month.
However, the price of the June call option with a strike price of $85 is two-and-a-half times greater
than the price of the March call. The June option expires in about four months. For an investor who pays
$5.48 to acquire this option, the share price must rise to at least $90.48 ($85 + $5.48) in the next four
months in order for exercising the option to produce a net profit. That represents an increase of about
8.4% from the current share price. Investors must think that an 8.4% gain in four months is more likely
than a 4.4% gain in one month because they are willing to pay more for the June call than the March call.
The same pattern holds for puts. The June put option sells for $3.60 more than the March put option
because investors recognise that the chance of a significant drop in Charybdis shares over a one-month
period is much lower than the chance of a large decrease over the next four months. In general, holding
other factors constant, call and put option prices increase as the time to expiration increases.^11
Next, let’s examine the prices of several Charybdis puts and calls, all of which expire in March. Table 8.3
lists the market prices of these options at 18 February 2016. Once again, a clear pattern emerges. Call option
prices fall as the strike price increases, and put option prices rise as the strike price increases. This relationship
is intuitive. A call option grants the right to buy shares at a fixed price. That right is more valuable the cheaper
the price at which the option holder can buy the shares. Conversely, put options grant the right to sell shares
at a fixed price. That right is more valuable the higher the price at which investors can sell.TaBle 8.3 PRICES OF MARCH OPTION CONTRACTS ON CHARYBDIS SHARES
The table shows the market prices of various call and put options on Charybdis shares at 18 February 2016 and 11
February 2016. The table illustrates that call prices increase and put prices decrease when the difference between the share
price and the exercise price (S − X) increases.18 February 2016 Charybdis = $83.44 11 February 2016 Charybdis = $86.70
Expiration Strike Call Put Call Put
March $80 $4.80 $ 1.68 $7.60 $0.88
March 85 2.15 4.00 4.18 2.48
March 90 0.85 7.85 1.95 5.25
March 95 0.34 12.30 0.78 9.1011 There are a few exceptions to this rule. Suppose you hold a European put option on a company that is about to go bankrupt. The company’s
share price will be nearly zero, and it cannot drop much farther. In this case, you would prefer to exercise your option immediately, rather than
having to wait to sell it, so the value of the option will decline as the time to expiration lengthens.TaBle 8.2 PRICES OF OPTION CONTRACTS ON CHARYBDIS
SHARES, 18 FEBRUARY 2016
The table shows the market prices of various call and put options on
Charybdis shares at 18 February 2016. Both call and put prices increase
as the expiration date moves from March to June to September.Charybdis price Expiration Strike Call Put
$83.44 March $85 $2.15 $4.00
83.44 June 85 5.48 7.60
83.44 September 85 7.24 8.70