European Call Options

In the CFAI texts they discuss the principle that a call option with a longer period to expiration has a value greater than or equal to one with a shorter period towards expiration. Under normal circumstances this makes sense, but they state it as if it always holds true in all scenarios. Consider a hypothetical scenario you have a European call option on crude expiring in 1 year and one expiring in 3 months. A tsunami has wrecked several pipelines causing a shortage and jacked up current prices that expected to taper off and revert to normal levels in linear fashion over the next year as these pipelines are rebuilt and supplies are restored to normal levels, in this scenario wouldn’t a 3 month European option be worth more than its 1 year counterpart?

You still have the possibility for multiple tsunamis to hit during the remaining 9 months of the other option…so, no.

Ok, so tsunami season has ended and likelyhood of multiple tsunamis is considered a non-material risk. So how about addressing the actual question and scenario I laid out which is one in which price expectations of the underlying are expected to decline steadily. How about a constructive post that actually addresses a realistic scenario from an open minded standpoint. And if you think the scenario is crazy as apparently Mark here does, all you have to do is think back to the extreme oil shortage through the south (especially around Atlanta) following the destruction of the pipelines following Katrina, and the tremendous spike in short term deliverable futures prices that followed.

I may have taken mark’s post the wrong way now that I read it again, in which case if it wasn’t meant to be sarcastic, then my bad.

Call options with longer maturities are worth more than ones with shorter maturities AS LONG AS THE UNDERLIER IS THE SAME.

Somehow I missed that, however, that makes sense now.

How much do we learn in those “smacking palm against forehead” moments?

That the palm hurts less than the fist?

Yep, chrismaths is out cold. Must have been one of those intense learning experiences.

JoeyDVivre, I still didn’t understand your point here. Could you pls elaborate a little bit more? From what I understand of the question, the underlier seems to be the same i.e. oil prices ; one with longer maturity than others. Where does the 18 month forward oil futures contract come into play with all this?

The 3 month contract on oil is a different contract to the 12 month contract on oil. They are two different underlyings - call them oil_3 and oil_12. JDV was saying if you wanted to make it a fair example, make the underlying the same. That could equally be oil_12 as oil_18. So long as the underlying expires after the option, you are ok!

Got it! Both fist and palm hurting this time … Thanks chrismaths.

But 3-month oil and 1-year oil are different things and the difference between the two is variable enough that it’s tradable. On Level III, you explore this stuff a lot. So at this very moment, 3 month oil (i.e., oil for delivery in July) is trading at 107.2 on Nymex. Oil for delivery in April, 2009 is trading at 102. That’s quite different from a stock where the forward price is some easily calculated value greater than the current price. I could buy options on April, 2009 oil (it would be an option on the oil futures contract most likely). Suppose that there are two options - one that expires in a 3-months and one that expires in a year (at the same time as the contract which is by far the most common kind of futures options). The 1-year option is surely worth more than the 3- month option because they are options on the same underlier but one has a longer maturity than the other. Suppose instead I bought 3-month European options on spot crude oil and 1-year options on spot crude oil. This would be the same as buying a European option on (former) a July 08 futures contract or (latter) a April 09 futures contract that expire when the contract expires. Everything about those options are different - the ATM on the former is 107.2 and the ATM for the latter is 102. They can have different volatilities and “smiles”. In LIII, you explore this stuff. For financials like stocks it’s much easier than consumable commodities like oil because the price of oil depends only slightly on previous prices of oil.

Joey, I hate to beat this into the ground, but the book (CFAI Book 6: Pages 158-159) just says that in all scenarios a European Call option with shorter time to expiration is worth less than one with a longer time to expiration and does not specify that it must be a call option on a forward or futures contract deliverable at the same time. They seem to be delivering it in the general sense. So what you’re saying makes sense, but what the book is saying seems to be making no such assumptions.

Well, uh, the book oversimplified or something. Just look at prices now. A 105 call option on spot oil would be ITM for July but OTM for April 09. Which one would be worth more isn’t clear because the first has more intrinsic value and the second likely has more time value.

I agree with Joey… the implicit assumption here is that the underlier is the same - strike, quantity and in the case of a lot of commodities, it’s quality and where it’s from all matter. In the case of a major market disruption (such as Katrina, terrorism), you will see that the longer dated options move higher than their shorter dated contracts by relatively the same amount, holding all else constant. So in the case that spot oil jumps up $20/bbl due to a storm, you would expect that both the short and longer dated options immediately adjust by $20/bbl at a minimum, with the longer dated contract rising more due to the added time value.

Yeah, I understood that in context of the same underlying, the CFAI text just didn’t make that specification so I was thinking of the difference between say oil in 3 months and oil in 1 year.