CALL OPTION BOUNDARIES
Hitherto we have focused on call option valuation on the date of its maturity. What will value before maturity? To explain the concept let us consider Example option is to buy the rating price on the exercise date is the call option has zero value, if the share price turns out to be higher than the option would have worth equivalent to the price of the share (S1) minus the exercise price (E). This position was depicted.
Even before maturity, the price or the call option can never remain the heavy line is the value of option can never and its worth will be at least equivalent to S - E when price of the share (before maturity) is the exercise price. Otherwise it will create/cause opportunity. Continuing with our Reliance share is (with strike price of Rs 12) and call option premium of Rs 5). Clearly, there are profit opportunities, that arbitrageur investor buy the inarticulately exercise 'it by buying shares at Rs 125, his local cost/investment is Rs 130 per share, by immediately selling it at Rs 130, the cams profit of share. What the hypothetical investor will also be applicable to other investors in the well-organized/ efficient markets. As a result, there will be more demand for call option till such time there is an upward revision of the option price. Therefore, to prevent arbitrage, the value of the all today (C) must be either greater than or equal to the difference of the share price today (S1) and the exercise price. In equation terms:
Co > So - E
From the above, it can be deduced that the call options which have still some time to run have lower bound either zero or S - E, whichever a higher. This has been depicted by point A.
The lower hound determines the Intrinsic value of till call option. The intrinsic value of a call this amount the option is the money over exercise, if it is out of the money (OTM). that is, the exercise price is higher than share price, its intrinsic value is zero. On the other hand, the time value of an option is the difference between the option premium and its intrinsic value. The longest time to expiration, the greater is an options time value, other things being equal. At expiration, an option would have no time value.
The highest value of the call option can never be more than the price of the share itself. This value can be reached only if the option has a very long time to expiration or is not likely to he exercised until far into the future. In these situations, the present value of the strike price to be paid in very distant future approaches zero. As a result, the value of the call option approaches the value of the share. Thus, lines A and B in represent the upper and lower boundaries.
However, in a realistic- practical situation, the call option price is likely to be in the shaded region (between lines A and B). The upper bound is more a theoretical possibility. This is so because if the share and the call option have the same price, every one will rush to sell the call option and buy the share. In fact, it is more likely to be an upward-sloping line (more dose to the lower bound) shown by the dashed curve, C In other words, curve C represents typical call option values at varied share prices, prior to maturity. The exact shape and position of the curve C depends on a number of factors. These factors have been explained in the following Section.