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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Let's explore a bit how the price of an option can vary, or how it can relate to the actual expiration date. So what I'm going to do is compare two similar options with the underlying stock being General Electric. And they're going to be the same in every way, except one is going to have a further out expiration date. So let's compare this call option right here. So this is a call option on GE with a $17 strike price. So it's the option to buy GE stock at $17. And it has an April, 2011 expiration. So it's going to expire, or the last day of trading that you could trade this option, will be the third Friday in April. Let's compare that with an option that has the same strike price, but has a December, 2011 expiration. So we're going to look for $17 strike price right over here. And you can see right when you compare the options that the one that has a further out expiration cost more. This one costs $3.25, while this one only cost $2.36. And the reason why it costs more is because you get to retain the option for longer. So you could imagine, $17. Let's say that $17 is right over here. Let me draw a hypothetical stock chart. So let's say that $17 is right over here. And so you could imagine, let's say, that you have both of those options. Or you have the option to have either one of those options. And let's say that the stock does something like that. Well, it's going to be in the money. You have the right, if you own either one of those options, you have the option to buy the stock at $17 and then sell it at whatever price this is. Maybe this price over here is like $20 something. So you would make money. But if you have the option with a closer expiration, with the April, 2011 expiration, you have to exercise the option right now. You would have to exercise it right now and close out the option. If you had the longer dated option, you could do it. You could do the exact same thing that this owner of an April, 2011 option has. Or you can hold the option and maybe see if the stock continues to go up. Or you could imagine a downside scenario. Maybe the stock does something like this, where it goes out of the money. Someone who holds the closer dated option, the one that expires first, they'll be completely out of the money. The option would be worthless on this date. But if you have the longer expiration, if your option does not expire until December of 2011, then you could hold it. And maybe, maybe the stock will do something nice. There's some probability that it will one day become in the money. I want to make it clear. Even if you have this situation here, and you hold the longer dated option-- you have the option that's going to expire in December-- you still would not want to exercise it. Because there is someone who would still enjoy all of this optionality of the future. So what you're better off doing, instead of exercising the option, you're better off selling the longer dated option right over there. And you should be able to capture at least as much profit as you would from exercising the option, plus capturing whatever value the buyer sees in the future optionality.