The Price of In-the-money Options

My posts of January 7 have defined what calls and puts are. I would like to get a closer look now on how the price of these contracts is affected by the underlying security price has this moves relative to the contract strike price. The transactions considered in my previous posts where between someone writing call or put contracts that did not exist before to someone else that is buying them for protection. Now I am going to look at someone buying and then selling the same contracts in the secondary market for options. In the previous case the writer of the contract has to honour the contract if the underlying stock is assigned to her. That is she has to sell the stock to the call buyer at the strike price or she has to buy the stock from the put buyer at the strike price. In the case considered here there are no obligations.

Let's take the example of Microsoft options. I will consider options expiring at the end of next week as this will show better the effect of time decay to the option price.

The following chart shows Microsoft stock price in the past six months:


Note how MSFT oscillates pretty much between $24 and $29.5 during this period.
Below we see the price of MSQ-AX, the call with strike at $22.5 expiring in January. It has always been in the money during the past six months. The main difference between MSFT and MSQ-AX appears to be the fact that it is on average 15% the price of MSFT, this factor oscillating between 10% and 20% over this period of time. The price of both securities appear to be moving about the same way. The consequence of this is that buying MSQ-AX instead of MSFT is giving me a considerable leverage. Let's see why. If I buy MSFT at $24.5 in October and I sell it at $28 in November, I gain 14.28%. On the other hand, if I buy MSQ-AX at $2.5 in October and I sell it at $5.5 in November, I gain 120%. That's the leverage.


If we now look at MSQ-AR, the call with strike at $24.5, we see a higher leverage, since the same trade would have gained by (3.5-1.25)/1.25 = 180%. This contract was actually at the money for a few days in October, when we are assuming to have started the trade.


And if we look at MSQ-AJ, with strike at $25, we see an even higher leverage, where the same trade would yield (3.25-1)/1 = 225%. This contract was slightly out of the money in October.



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