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Question By Ray
"Why Option Price Below Intrinsic Value?"
Why is an Option Price well below the Intrinsic value when there is still time left to expiry. For example, I bought a JPM Aug2012 Put @ $40 for $6.20 and the current Option Price is $5.00 when the JPM Share Price is $35.09.
Asked on 17 July 2012
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Answered by Mr. OppiE
Hi Ray,
Indeed, the price of an option should never be below its intrinsic value otherwise an arbitrage opportunity would occur which is extremely rare and shortlived. There is a situation in which an option's price can be seemingly significantly and sometimes ridiculously below its intrinsic value and that is when it is an Adjusted Option. However, that is not the case in your question as the option in question is a plain vanilla regular option.
I took a quick look at the prices of that option after market and it is asking at $5.05 and bidding at $4.95 with last price being $5.00. First and foremost, you need to be clear that, unlike stocks, the last price of an option do not reflect its fair market value or "Current Option Price". This is due to the fact that options do not need to be traded (unlike stocks) in order to have a price change. Options prices can change without being traded due to factors governed by the options greeks. The last price of an option reflects the price it was last traded, which could be a long time ago for less heavily traded options. In fact, you could get something like $5.00 as the last price while the ask price is $10.50 with a $10.00 bid price if the option hadn't been traded for quite some time. As such, the price of an option cannot be determined through its last price (read more about Options Prices). The value of an option for a person looking to buy an option is the ask price while the value of an option for a person looking to sell an option is the bid price. Those are the prices that you can trade a particular option at immediately.
In this case, the last price of $5.00 happens to be smack in between the bid and ask price, giving the illusion that it is the fair market price, so don't be misled and deceived because not all last prices are like that.
Next thing to clear up would be how intrinsic value is determined in the first place. The intrinsic value of an in the money put option is determined by deducting the strike price against the stock price. In this case, the intrinsic value of the JPM Aug2012 $40 Put would be $40 - $35.09 = $4.91. This means that if you buy JPM stocks for $35.09 now while simultaneously exercise your put options and sold them at $40, you would make a profit of $4.91 on that sale. Of course you won't have made any money since you also paid that much in intrinsic value in buying the put options which evaporates immediately the moment you exercise those options.
If you look now at the ask price of $5.05 (for buying), you would see clearly that there is an extrinsic value of $5.05 - $4.91 = $0.14, which is the premium to expiration. The option is clearly not "well below the Intrinsic value" as you mentioned in your question. In fact, even the bid price of $4.95 contains $0.04 of extrinsic value.
In conclusion, you probably arrived at the wrong conclusion due to the combined effect of not completely understanding options prices and the calculation for intrinsic value. Please read up on these topics on www.Optiontradingpedia.com and I am sure you will be a much better options trader in time to come.
Response by Ray...
Reply by Mr. OppiE...
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