Why do options with the same underlying stock and strike prices trade for different amounts?

By Albert Phung AAA
A:

You would think that two options with the same underlying stock and strike prices would trade at the same price, but interestingly enough, they most often trade at different prices.

For example, as of November 20, 2006, Bank of America had a call option with a strike price of $50 that was set to expire in January 2007 (BAC AJ) and another one with the same strike price that was set to expire in January of 2009 (VBA AJ). In this case, BAC AJ was worth $5, whereas VBA AJ was worth $7.80.

The BAC option's worth on November 20 was fairly close to its intrinsic value (the underlying stock was trading at $54.96), but the other option with the same strike price was selling at a slightly higher price. The differences in time to expiration between these two options is what accounts for the differences in market price.

While an option's intrinsic value is one of the biggest determinants of its price, its time value also affects the price that a trader pays. Generally, for American style options, the longer the option's life before expiration, the more valuable it is because the option holder receives more opportunities to gain upside benefit with more time in hand.

For example, a call option for BAC with a strike price of $70 will be trading at lower values if its expiration is in a month compared to an expiration of two years. This is because it is unlikely that the stock will rise $15 in a month. On the other hand, the same option that expires in two years is usually considered more valuable because the underlying stock has more opportunity to grow to $70.

This time value decreases over time as expiration approaches. At the time of expiration, the option's value will reflect the option's intrinsic value.

For more information on options, see Options Basics Tutorial, Option Spread Strategies and The Importance Of Time Value.

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