Options newb here... Was looking for a way to reduce exposure to craziness and started pricing options. Intrinsic value cannot go negative. So what does negative time value mean? I've seen it pop up a few times. Example: XYZ - 100.00 XYZ Oct08 Nov 50 Call - b: 48.00 a: 49.00 I know, the writer isn't giving away money. So what am I missing?
This scenario cannot happen during normal conditions or else everyone would buy the call at 49 and short the stock at 100. Then exercise the call, locking in $100, less commissions. So what's different? a) It could be the stock stopped trading and issued bad news. Thus, the last option price quoted was below market. Very unlikely. b) This could simply be bad data. Is your data live, or are you getting end of day data from some bad place, such as Yahoo? Their market data is terrible. I suspect this is the problem. c) It could be a European style index option - with no early exercise. But that feels wrong also. Can you provide more information on how/when you see these aberrations. Mark
Thanks, Mark. I found that I was looking at some non-standard; exotic options. Take for example: QID - 63.00 DMRVFX - Oct 2008 110.0000 put b42.30 - a45.00 Several dollars negative intrinsic. So I'm wondering where I could find the terms of the exotic option? I'm wondering if it has to do with the proshares moving to a new exchange... Just trying to figure out the value (and behavior) of these nonstandard options so I can price them. How could I investigate the terms of the contract?
QID didn't close at $63, thats the problem. Closed at $67 and change. You're referring to "non-standard" options too, not "exotic" . For options adjustments (ie. in a merger situation) look at the OCC's website.
European style options are priced as actual value (present value) of expected final payoff. So it's needed to discount actual payoff by 1+interest rate for the period. Hence for deep in the money european calls you may see negative time value. If you want to see that, price a european call deep in the money with high interest rate. Back to your example, If interest rate 2% and spot at 100, a one year european style 50 call is worth present value of option intrinsec value, that means present value of (100-50)=50, that is around 49,01... (50/(1+0,02)). If interest rates were around 30%, the same call would be worth 38,46 (50/(1+0,3)). If the spot stay that level, each days increase option value to 50 target at maturity. Theta is then negative. Same thing for a put.
Here a picture of european style call option. If spot soars beyond 86, call would be deep in the money and time value will get negative. http://www.hoadley.net/options/optiongraphs.aspx?divs=Y
There are cost-of-carry issues to consider that the "rocket scientist trading houses" have priced into the option. Borrowing costs, shorting costs and dividends would be the bigger influences.