Models for Call Option Decisions

Abstract

THE PURPOSE OF THIS PAPER iS to develop models for buying and selling options. The paper is presented from the point of view of call options, but the methodology could be modified for puts, straddles and spreads. The valuation process yields the expected value of a call option as estimated on the day of valuation, which can be at any time before or after acquiring it, before its expiration. The process can be used for decisions on purchasing call options, or for decisions on holding, exercising, or selling call options already owned. A call option is quoted terms of contract price, expiration date, and price of call. Options are usually written lots of 100 shares. If the holder of a call option chooses to exercise the call on any day on or before the expiration date, he receives the stock at the contract price, paying the sales commission. He typically then sells the stock at market price, receiving market price less (another) sales commis.sion. There are small taxes involved buying the option initially, and exercising it. The. holder of the call option receives any dividends paid before the option is exercised. We consider the. case where the decision maker plans to exercise the call option and sell the stock, thus paying two sales commissions. Valuation before purchase of a call option involves assessing the expected value of the option and comparing it with the price of the option. If the expected value is greater than the price, the decision maker should typically be willing to buy the call option. Valuation of a call option already owned involves deciding whether to hold the option, exercise the option, or sell the option at an offered price. At any time during the length of the option (up, to the last two weeks or so, usually) there may be a m.arket for the option, particularly if it is in the money and the issue is volatile at the time. If the expected value of holding the option is greater than the known values of exercising or selling, the decision maker should typically be willing to hold the call option. He should choose the course of action with the highest value to him.