Can Someone explain time premium with relation to puts and calls

[MTE]

Quote from Pabst:

Riskarb: I've heard the term contango for many years and never knew what it meant. Is the definition, "carry to expiration"?

Contango means that as you go further out the price of the contracts increases.

Backwardation is the opposite of contango. Usually happens when there's a shortage of commodity.

For example, if you look at silver futures then they are in contango: CBOT silver futures

And the copper futures at NYMEX are in backwardation: NYMEX copper (just select "I agree" at the bottom of the webpage and then look at the "most recent settle" column)

 

[riskarb]

Quote from MTE:

Contango means that as you go further out the price of the contracts increases.

Backwardation is the opposite of contango. Usually happens whne the demand is great than supply.

For example, if you look at silver futures then they are in contango: CBOT silver futures

And the copper futures at NYMEX are in backwardation: NYMEX copper (just select "I agree" at the bottom of the webpage and then look at the "most recent settle" column)

The mention of Copper is interesting. There is tremendous time-spread or "switch" sensitivity in trading non-financial markets like copper and other physical commodities.

Often a market maker will be asked to make a market in a back month option in which he/she has a defined-edge. More often than not, as in the case of copper, the back month futures are very illiquid for the give-up on the hedge. The option market maker will often trade his deltas in the the liquid front month futures, often with fatal results due to futures time spread risk.

 

[kny3]

Gnome,

Sorry for sharp reply to you, was running to a meeting ("meetings are our most important product"), I was confident members would step in with a better explanation, and they did.

To see how interest rates come into play, use any options pricing calculator (easy one to find is Options Toolbox at www.cboe.com).

I just keyed in $75 stock, 75 strike, 30 volatility, 0% interest rate, 30 days. Call AND Put both worth 2.57. Change the interest rate to 5% - Call worth 2.72 but Put only worth 2.44. Changes in interest rates with short term options one of the least important factors of option pricing.

kny 3

 

[volatilitypimp]

Quote from riskarb:

The mention of Copper is interesting. There is tremendous time-spread or "switch" sensitivity in trading non-financial markets like copper and other physical commodities.

Often a market maker will be asked to make a market in a back month option in which he/she has a defined-edge. More often than not, as in the case of copper, the back month futures are very illiquid for the give-up on the hedge. The option market maker will often trade his deltas in the the liquid front month futures, often with fatal results due to futures time spread risk.

Incidentally, did u hear about a hedgie being squeezed in copper? I'm looking at a six to eight month call ratio backspread to take advantage. would backwardation play any significant role here? thx.

 

[jj90]

Quote from riskarb:

Carry has nothing to do with decay. ITM euro-ex puts can trade at a discount to intrinsic value, = carry. They can appear to maintain +theta or gaining IV as the time to expiration nears and the ITM euro-put converges to intrinsic value at expiration. The rate of convergence is = the carry on holding the long put strike. It may seem as though vols are increasing, but it's already trading at a discount. Vol-strips can decrease rapidly, but the convergence will still be evident. This isn't an issue with american-exercise.

Same-strike calls and puts decay at the same rate, arb[model] dependent[independent].

Risk, could you explain on this? I've known about this, but never really understood how it worked.

 

[neophyte321]

Assuming an equal chance of moving up or down, does this make short-term put buying inherently advantageous? Or in the short-term is the carry cost somewhat neglible?

 

[kny3]

Hey jj90.
Riskarb is right again.
SPX deep in-the-money puts a good example today. With SPX at 1306, the 1400 strike put, 94 points i-t-m, these were the prices (I'm rounding to a # between the bid/ask)

May 91.40
Jun 86
Jul 82.40
Sep 81.40

Sep shows first sign of higher vol (~10).

Dec 83 vol 11.4
Mar '07 87 vol 12.4
Jun '07 89 vol 13

First months to reflect volatility, but all of these prices still under parity and reflect cost of carry. Hope this helps

kny 3

 

[DJR]

major difference is determined by whether or not the option is an American style...and can be exercised at any time, or a European style....and can only be exercised at expiry.
Some exchanges have both...even down to both in the same month and similar strikes so be aware of which you are dealing in.