Question

Question 3

Explain why an option’s time value is greatest when the stock price is near the exercise price and why it nearly disappears when the option is deep-in- or out-of- the-money. (5Marks)

Callpricesaredirectlyrelatedtothestock’svolatility,yethighervolatilitymeansthat
the stock price can go lower. How would you resolve this apparent paradox?

Answer 1

Solution:

Option’s time value is greatest when the stock price is near the exercise price.

Option Premium = Intrinsic value + Time value

Intrinsic value is always In the money (ITM)

For Call option = spot price - strike price

For Put option = strike price - spot price

Thus, from the above scenarios:

If the spot price and strike price are almost near to each other, Intrinsic value will be very less. option premium being higher in In the Money will automatically result to higher Time Value.

Solution:

Time Value nearly disappears when the option is deep in or out of money.

When the option is Deep ITM or OTM, the option premium is near the minimum range.

Because Deep ITM and Deep OTM is when Spot price is very higher than the stike price (Call option ) and vice versa (put option).

Thus it reduces time value.

Solution:

In options, volatility directly and aggresively affects the option prices. Whatever the underlying asset class it is, higher volatility (upside or downside), it is going to affect both type of options.

Eg. In current Covid-19 scenario, there is volatility in each and every asset class. People are unsure about the future movements or targets, thus volatility creates higher risks which directly increases option prices.