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View Full Version : why are FDG 2008 call options below market price?


blendedsuit
11-21-2005, 12:34 PM
For instance the $30 call options expiring in 2008 currently have a bid of only 5.80 per share, while the market price of the stock is 35.95.

Another unconsistency I observe is that the JUNE calls of 2006 are being traded at higher prices than the Jan 08 calls. Bids of 6.20 for June, even the Dec '05's are also at $5.80. Why on earth would someone buy a Dec '05 call at $5.80 when they can get a Jan '08 for the exact same price.

Sniper
11-21-2005, 01:14 PM
When you trade options you are generally buying at the ask, and selling at the bid (unless you can get someone to trade with you at a price in the middle)...

FDG is currently trading at 36.20

The current market for FDG 30 calls:
Dec '05 - Bid: 6.30 Ask: 6.90
Jan '06 - Bid: 6.10 Ask: 6.90
Jun '06 - Bid: 6.50 Ask: 7.50
Jan '07 - Bid: 6.50 Ask: 7.40
Jan '08 - Bid: 6.10 Ask: 7.50

These options all trade light volume (if they trade at all on any given day).

blendedsuit
11-21-2005, 01:20 PM
[ QUOTE ]

FDG is currently trading at 36.20

The current market for FDG 30 calls:
Dec '05 - Bid: 6.30 Ask: 6.90
Jan '06 - Bid: 6.10 Ask: 6.90
Jun '06 - Bid: 6.50 Ask: 7.50
Jan '07 - Bid: 6.50 Ask: 7.40
Jan '08 - Bid: 6.10 Ask: 7.50

These options all trade light volume (if they trade at all on any given day).

[/ QUOTE ]
I don't understand why people are not paying more for calls further in the future.

Why is the bid for Jan '08 less than all the other options which expire sooner???

Sniper
11-21-2005, 01:29 PM
[ QUOTE ]
I don't understand why people are not paying more for calls further in the future.

[/ QUOTE ]

Because the options are very thinly traded, and thus the market maker can try to take advantage of "the fish" by offering to buy back someones option below its true value.

The true value for each of those options is somewhere in between the bid & ask.

Sniper
11-21-2005, 01:32 PM
FWIW, if you are new to option trading, I highly recommend you stick to options that are more actively traded, as the bid-ask spreads will generally be tighter.

blendedsuit
11-21-2005, 02:04 PM
I wouldn't consider myself a newbie at options, but I agree wholeheartly that these options have a very low volume and thus larger bid ask spreads. I bought some FDG call options a while back at no premium whatsoever. Meaning, the options had a strike at 30, I paid 4.90 per share, and the current market price was 34.90. I am comfortable with the investment I made.

I was just wondering if there were any other reasons besides the lack of interest in these options that would create the current situation where the calls further off in the future are actually priced lower than the more recent ones.

buffett
11-21-2005, 05:57 PM
Great quote from Charlie Munger at the 2003 BRK AGM:

Black-Scholes is a know-nothing system. If you know nothing about value -- only price -- then Black-Scholes is a pretty good guess at what a 90-day option might be worth. But the minute you get into longer periods of time, it's crazy to get into Black-Scholes. For example, at Costco [where he is a board member] we issued stock options with strike prices of $30 and $60, and Black-Scholes valued the $60 ones higher. This is insane.

FatOtt
11-21-2005, 11:56 PM
[ QUOTE ]

Great quote from Charlie Munger at the 2003 BRK AGM:

Black-Scholes is a know-nothing system. If you know nothing about value -- only price -- then Black-Scholes is a pretty good guess at what a 90-day option might be worth. But the minute you get into longer periods of time, it's crazy to get into Black-Scholes. For example, at Costco [where he is a board member] we issued stock options with strike prices of $30 and $60, and Black-Scholes valued the $60 ones higher. This is insane.

[/ QUOTE ]

I hate this quote and I was in the audience when he said it. With the Costco example, he's acting as if there was no change in the information environment between the time when those options were issued. If the strike=$30 and the strike=$60 options were issued on the same date, Black-Scholes would obviously value the $30 strike option higher (as would all option pricing formulas). The problem is that things aren't the same.

A trivial example:
On Jan. 1, COST issues options with a strike price equal to market price equal to $60.
On Jan. 2, after a 2-1 stock split, COST issues options with a strike price equal to market price equal to $30.

Most people (including Munger) would say that you'd have to receive twice as many options at the $30 strike to equal the value of the $60 options.

Maybe that's an overly trivial response, but his point is still stupid. He'd make the same argument for stock prices:
"I received a share of stock from COST when it was trading at $60 on Jan 15 and I received another share of stock on May 15 when it was trading at $30. Obviously those two stocks are worth the same amount - they represent the same degree of ownership in COST and the same right to future cash flows. Yet the accounting system would say they actually cost different amounts of money! How stupid." But is that really stupid? Shouldn't you value a particular security based on the information environment at the date of the transaction?

Another example:
You own a security whose payoff is dependent on the roll of two dice. You receive $1,000*the total points rolled. You receive one share of this security before a die is rolled - what's the value of that security at that point in time? It's $7,000. Then the first die is rolled - a 4 comes up. What's the value of the security? It's now $4,000+$3,500 = $7,500. But it's the same security - what kind of pricing system would value the exact same security at $7,000 and $7,500 simply because some time has passed?

Munger's obviously a smart guy, but he often takes shortcuts with his comments that do not reflect his understanding of a topic. That's fine for him - I trust that he understands the details of what he makes offhanded reference to. I feel bad for the people, though, that listen to his quips and use that as the sole basis for economic proclamations. (Not referring to you, Buffett, I've read your posts before and don't think you're guilty of this.)

Sniper
11-22-2005, 09:38 AM
[ QUOTE ]
I was just wondering if there were any other reasons besides the lack of interest in these options that would create the current situation where the calls further off in the future are actually priced lower than the more recent ones.

[/ QUOTE ]

Just give it some more thought.. remember, its an auction market... and if there is little interest, the prices can be marked at anything.

buffett
11-22-2005, 10:21 AM
[ QUOTE ]
If the strike=$30 and the strike=$60 options were issued on the same date, Black-Scholes would obviously value the $30 strike option higher (as would all option pricing formulas).

[/ QUOTE ]
I thought that was exactly his point. They had the same expiration (I don't see how the date of issue matters, but of course expiration does), but the $60s were higher, which prompted his remark of "insane."
At any rate, it seems that neither you nor I have all the facts Charlie had when he made his comment, but I tend to give Charlie (who is much more of a genius and a billionaire than I am) the benefit of the doubt.
-web

SuitedPair
11-22-2005, 10:23 AM
The main reason is the high dividend yield the stock pays. Typically, when the dividend is paid the stock drops by the amount of the dividend, otherwise there would be a great arbitrage opportunity. Since this is a high dividend paying stock and investors think that the company will continue to pay dividends in the future the stock price will be reduced by the dividend amount more in the out years.

Another aspect is the seller of the call will likely be collecting the dividend. When he sells the call to you he would likely buy the stock to hedge his book. Since he is long the stock he will collect the dividend. This would also make the call option less attractive compared to owning the stock outright, thus lowering the price an investor should be willing to pay for the call option.

These are active options, just eyeballing open interest it looks over 100,000. There are several investors that arbitrage these high dividend stocks betting on future dividend payments.

I'd bet that investors are betting that the div. drops causing the share price to drop. ( I know that seems counter to the first paragraph, but I think you know what I'm getting at).

Iím not sure how clear any of this is, Iím rushing before the open.

Sniper
11-22-2005, 10:40 AM
[ QUOTE ]
At any rate, it seems that neither you nor I have all the facts Charlie had when he made his comment,

[/ QUOTE ]

Buff, how can you possibly evaluate the comment, without all the facts?

edtost
11-22-2005, 11:44 AM
[ QUOTE ]
[ QUOTE ]
If the strike=$30 and the strike=$60 options were issued on the same date, Black-Scholes would obviously value the $30 strike option higher (as would all option pricing formulas).

[/ QUOTE ]
I thought that was exactly his point. They had the same expiration (I don't see how the date of issue matters, but of course expiration does)

[/ QUOTE ]

if they were issued at different times, and he measured prices when each one was issued, any relation between the two is possible.

note that i have no idea when he measured prices or whether they were in fact issued at the same time.

buffett
11-22-2005, 11:52 AM
[ QUOTE ]
how can you possibly evaluate the comment, without all the facts?

[/ QUOTE ]
That's all investing (and maybe even life) is....making decisions with imperfect/incomplete information. You've gotta make judgment calls, assumptions, extrapolations, etc.

FatOtt
11-22-2005, 11:54 AM
[ QUOTE ]

if they were issued at different times, and he measured prices when each one was issued, any relation between the two is possible.

note that i have no idea when he measured prices or whether they were in fact issued at the same time.

[/ QUOTE ]

They were issued at different times. Both sets of options under comparison were issued at strike price = market price, and thus different times.

FatOtt
11-22-2005, 12:00 PM
[ QUOTE ]
If the strike=$30 and the strike=$60 options were issued on the same date, Black-Scholes would obviously value the $30 strike option higher (as would all option pricing formulas).

[/ QUOTE ]

[ QUOTE ]
I thought that was exactly his point. They had the same expiration (I don't see how the date of issue matters, but of course expiration does), but the $60s were higher, which prompted his remark of "insane."

[/ QUOTE ]

No, I'm saying that Black-Scholes (the tool that Munger hates) would value the k=30 and k=60 options such that the k=30 option was more valuable. Munger's statement refers to the fact that Costco issued options at k=60 and options at k=30 (separate times). At the issue dates, the k=60 options were worth more (according to Black-Scholes) than the k=30 options. His argument was, "How can the option to buy something at $60 be worth more then the option to buy that very same thing at $30?" He completely ignored that the stock price itself (the perceived value of the firm) had changed between the two issue dates.

I'm not even saying that Black-Scholes is good or bad, but Munger's argument in this case is bad. As edtoast noted, unless the two options are granted on the same date (into the same environment, with the same underlying's expectations), any comparison between the model's prices is faulty.