By Sunil Parameswaran
Traders who are new to options, may wonder why they have to pay a premium to buy an option, considering the fact that a premium is not required to buy a futures contract. The answer lies in the fact that the former is a contingent contract, while the latter is a commitment contract. In the case of a futures contract, once the position is taken, both the long and the short face the spectre of a negative cash flow.
However, in the case of options, once the contract is entered into, the long will have either a positive or a nil cash flow, while the short will have a negative or a nil cash flow. This is the reason why options, both calls and puts, require the longs to pay a premium to the shorts at inception.
Call and put options
Option premiums can never be negative. A negative premium would imply that a trader is willing to pay you to buy an option. If so, buy it, knowing fully well that the subsequent cash flow will either be positive or nil. Consequently, this is a clear case or arbitrage. Hence, both call and put options, whether European or American, entail the payment of a positive premium at the outset, by the buyers.
The premium consists of two components, the intrinsic value and the time value. The intrinsic value is what the holder would get if it were to be immediately exercised. It is thus equal to the extent to which the option is in-the-money if it is in the in-the-money, or zero if the option is out-of-the money or at-the-money. Thus, the intrinsic value cannot be negative.
The difference between the option premium and the intrinsic value is termed as the time value or the speculative value of the option. This is the additional premium paid by the buyer for the option to wait and exercise subsequently. American options cannot have a negative time value, that is, the premium must be greater than or equal to the intrinsic value.
European calls on a non-dividend paying stock also cannot have a negative time value. However, European puts on a stock and European calls on a dividend paying stock may have a negative time value. This may be appreciated as follows. Assume the stock price is close to zero. The holder of a European put would love to exercise, but is constrained by the fact that the exercise date is further away. This could cause the option to have a negative time value. In the case of European call on a dividend paying stock, the holder may like to exercise and capture the dividend. However, the European nature of the option precludes him from doing so. Consequently, the time value may be negative.
The upper limit for the call premium is the stock price. Nobody will pay more than the stock price to acquire an option, which entails the subsequent payment if an exercise price if exercised. If the stock is so attractive, might as well acquire it now. The upper limit for an American put is the exercise price, while that for a European put is the present value of the exercise price. The lowest possible stock price is zero. Thus, the upper bound for the former is the exercise price. In the case of the latter, this cash flow will be realised only at expiration. Hence, the upper bound is the present value of the exercise price.
The writer is CEO, Tarheel Consultancy Services