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Time and moneyness


All else equal, more recently granted options have more upside since their expiration dates are further in the future, and so they have a longer period of time to benefit from stock Volatility. However, volatility exposes the option holder to the possibility of stock price decline as well as the possibility of a stock price increase. The reduction in the value of an option due to a stock price decline is limited by the exercise price. Thus, for a Deep-in-the-money option, the potential loss from a stock price decline is much greater than for a Near-the-money option. The potential loss is avoided when the option is exercised. This can lead to the decision to exercise a long-maturity, deep-in-the-money option before a short-maturity, near-the-money option.

The option calculator can be useful in assessing this tradeoff. The difference between the Fair value, F, and the Intrinsic value, I, represents the expected net benefit from continuing to hold the option, B. That is F-I=B, or F=I+B. The net benefit, B, is the potential for further stock price appreciation, offset against the potential for a stock price decline. By exercising, one captures I and forgoes B. Increases in Moneyness (i.e., the amount by which the option is in the money) increase I. Increases in the time to expiration increase B. The option calculator provides an estimate of the fraction of the option value captured by immediate exercise, which is I/F. Given that some options must be exercised, the strategy of exercising those for which the intrinsic value is the largest portion of the option's fair value merits consideration.

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Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
huddart@psu.edu
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http://personal.psu.edu/sjh11/ValuationConsiderations/TimeAndMoneyness.shtml
was last updated on Tue, Aug 21, 2018.
Today is Fri, Nov 15, 2019.

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