Question

1. As an option approaches the expiration date, what should happen to the price of the option?

2. Suppose we have two stocks and the price of stock A is much more volatile than the price of stock B. Which stock should have a higher premium?

Answer 1

1. Price of Optiion have two components:

• Intrinsic Value
• Extrinsic Value

Intrinsic value is the amount that can be obtained by immediate exercise of the option right. For example if a share has market price of $40 and you buy a Call option at Strike Price of $35.expiration after 3 months and premium of $9.By buying the call option, you have right (But not obligation)to purchase the share at $ 35. The Option Seller has the obligation to sell the share at $35 to you when you exercise the option.You can buy the share at $35 and sell in the market at $40 and make profit of $5.

Hence intrinsic value of the above option is $5

Total Premium =$9

Hence $(9-5)=$4 is the extrinsic value

Extrinsic Value partly depends on the time to expire . That is why it is known as Time Value. As the time to expire decreases, the premium or the price of option decreases. As an option approaches expiration,date, price of option decreases.

2.The Extrinsic value also partly depends on the volatility of the price of the stock. The higher volatility , higher will be the likely amount of payoff from the option. Hence, the option price will be higher.

In this case Stock A will have a higher premium